On Monday, the S&P 500 fell by 1.7% for its worst day since May 12, 2021. Other equity benchmarks, both domestic and foreign, fared similarly as investors feared that a default by Chinese real estate developer Evergrande might spread to global markets.
Investors are also on edge due to the Federal Reserve’s policy meeting this week. The central bank will be updating the dot-plot showing FOMC members’ projections for future rate moves. Any deviation from investors’ expectations could spook the markets further.
With the bull market in its second year and many concerned over valuations, it is no surprised markets are on edge. In this environment, options-based strategies meant to temper risk have proliferated and gathered assets with relative ease.
The International Drawdown Managed Equity ETF (IDME) launched two months ago and has already gathered $84 million in assets under management. The fund has an expense ratio of 0.65%, more than double that of the iShares MSCI ACWI ex U.S. ETF (ACWX), which offers unhedged exposure to international equities.
Chart courtesy of FactSet
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IDME is the latest in Aptus Capital Advisors’ suite of actively hedged ETF strategies. Unlike defined outcome strategies, which provide downside protection in exchange for a cap on the upside, Aptus’ goal is to keep up when markets appreciate while still maintaining that downside protection.
According to JD Gardner, founder and portfolio manager of Aptus, “If markets are rising, we don’t want shareholders to even realize there’s a hedge inside the fund. Hedge is naturally a drag, and if we can disguise that drag through how we’re deploying strategies, that’s a really compelling situation, because your upside capture should be attractive relative to your downside.”
The issuer has had mixed results in terms of achieving this goal. The Aptus Drawdown Managed Equity ETF (ADME) is the firm’s ETF focused on large cap U.S. stocks. The fund invests in 50-60 companies while limiting downside risk through the purchase of puts. The fund can also write puts and hold VIX index call options.
Though the fund has an inception date in June 2016, the fund took a different approach prior to November 2019. Since this new philosophy has been in place, the fund has had periods of over- and underperformance relative to the SPDR S&P 500 ETF Trust (SPY).
ADME protected significantly during the market drawdown in February and March of last year. From February 15 to March 23, SPY fell by -33.6%, while ADME only lost -16.6%.
In the strong up-market since, ADME has lagged on the upside due to the cost of hedging the portfolio from downside risk. When considering how the ETF might perform over a full market cycle, ADME would not have to rise quite as fast as SPY to outperform due to the downside protection. In prolonged down markets, ADME might have better results.
Fixed Income Alternative
The Aptus Defined Risk ETF (DRSK) is the firm’s largest fund by assets under management, having gathered $813 million since launch in August 2018. The ETF combines corporate bond exposure with an overlay of call options on U.S. large cap stocks.
This unique combination means that the ETF has a similar risk profile to that of other corporate bond ETFs with the potential for higher returns. The fund has been successful in achieving this goal since launch, outperforming the Vanguard Intermediate-Term Corporate Bond ETF (VCIT) by 5.8%.
DRSK had a smaller drawdown during February and March of last year, and has gained nearly 12% more since the market bottom in late March 2020.
Due Diligence Important
In a low-rate environment with credit spreads remaining at historically tight levels, shifting the allocation from equity to fixed income means trading in one type of risk for another. With inflation measures running hot, longevity risk could also be an issue for client portfolios.
Options-based strategies can be a tool to help advisors solve the problem of taking equity risk off the table without adding an abundance of other risks in its place.
These strategies are typically more complex than traditional equity or fixed income strategies. For that reason, advisors should take care to ensure they understand how each ETF should perform. Some ETFs are best suited as an equity replacement, while some act as more of a bond proxy.
As these ETFs’ track records grow longer, past performance can also provide hints on how these ETFs stand up to times of market stress. But as we saw with ADME, the inception date is not necessarily the best starting date to use when assessing the fund’s performance.