The month of February, and midterm election years in particular, have a history of being bad for stocks. The cash drain among the mega-cap tech stocks that have led the market for years has been stressing heady market valuations, with Amazon headed back to a negative free cash flow situation and Alphabet dipping deeply into the bond market to finance its data center buildout — and it is far from alone in seeking debt market financing related to AI. The threat from AI to sectors across the market was walloping companies from software to trucking to commercial real estate as new worst-case scenarios were theorized about on an almost daily basis.
All of that resulted in an S&P 500 that has gone nowhere this year, with a return of less than one-half of one percent for an index that is likely to see more volatility in the week ahead. But after three years of gains — and even before the uncertainty of a prolonged war in the Middle East and the prospect of $100 oil tipping the global economy into recession — a few months of sideways trading was not a shock to investors. They have been increasingly moving away from bonds as the primary hedge against the stock market and it’s not just gold, up another 20% this year, that has boomed. Investors have been turning to options-based exchange-traded funds in increasing numbers over the past few years as a result of fears about the sustainability of the stock market’s run combined with the need to generate income among many older Americans.
According to ETF Action founding partner Mike Akins, one of the most notable splits in the ETF world is between the heavy use of “the big box categories,” core stock and bond index funds, by institutional investors — where as much as 60-70% of ownership is institutional — versus the ownership of “non-traditional” ETFs in areas that have now grown to include many options-based ETF strategies and has been one of the biggest product development trends in recent years. There has been an estimated $170 billion invested in “synthetic income” ETFs which use options to focus on generating income, and $100 billion in “buffer” ETFs that use options to focus on downside protection — with most of the assets coming from retail investors or investment advisors for their individual investor clients, Akins said on the most recent episode of CNBC’s “ETF Edge.”
According to Tidal Financial Group senior vice president of product development Aga Kuplinska, the market is in the “overlay everything” phase as issuers take any underlying asset class or strategy and layer on options strategies for income and hedging. It’s no longer just in areas where the search for income has long been a focus such as dividend stocks, but for areas of the market long associated purely with the search for growth like tech stocks. “Income has been the No. 1 selling point and will remain so going into future because the demand for yield just doesn’t go away and during uncertain market conditions the added benefit of income seems to resonate well with investors,” she said on “ETF Edge.”
While institutions have long used similar strategies, the availability of the options-based strategies in an ETF wrapper has made it more efficient for retail investors to access this approach, and Akins warned that “in some respects, with synthetic income in particular, we’ve gotten to the Wild West in terms of what we can do.”
The ETF experts said there are successful examples of fund companies generating both maximum income for investors from these strategies and those generating a more conservative level of income. In the tech stock-concentrated Nasdaq 100 synonymous with the Invesco QQQ ETF (QQQ), for example, there are options-based ETFs that have performed well amid the tech tumult and have been a “nice solution for investors to generate income off a more volatile strategy while still getting upside,” Akins said.
Nevertheless, Kuplinska added that investors need to start from the understanding that “there is no free lunch in options income. The more income, the more upside you typically give up.”
Akins said that some of the yields on offer are so high investors need to understand what it means for a fund’s net asset value. With some ETFs indicating yields or distribution rates at almost 100%, in effect that means almost equivalent erosion of the fund’s net asset value — otherwise known as a “yield trap.” The range of yields in this growing strategic ETF niche is wide — with some ETFs targeting 5-8% and others 8-12%, as well as those verging on 100% — but it is a signal that “lots of education has to be done,” Akins said.
Kuplinska said with any derivatives-based income or hedging ETF strategy, what is taking place behind the scenes at the investment manager running the fund is very important, from regulatory and compliance protocols to the sophistication level of the trading desk. “These are incredibly difficult strategies to back test,” she said on the podcast portion of “ETF Edge.” She noted these ETFs are all subject to regulatory requirements to calculate risk on a daily basis, but she added, “Anything can be a weapon of mass destruction if not used as intended or properly.”
After the the past few years of rapid launches within this ETF category, “white space is much harder to find,” Kuplinska said. Options-based investing has “been done on everything out there,” she said. But she does think one more wave of options-based ETFs is coming and it will be less about the chase for maximum yield levels and designed more to focus on income stability and risk control.
You can watch their conversation from the most recent “ETF Edge” above to learn more about proper use of options-based ETFs.
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