A Tamer Take On Mega Cap Growth

August 30, 2021

After a brief slump in the spring, growth stocks have come back into favor with investors. The 10-year U.S. Treasury yield has fallen from 1.7% at the beginning of April to 1.3%, a decline of nearly 25%. This rate slump has fueled growth names as inflation worries have abated.

For investors who are worried that growth valuations might have gotten ahead of themselves, option-based strategies that provide exposure to these names might be a valuable way to take some risk off the table.

Though growth stocks have dominated value for the past decade, the past two years have been especially kind to stocks such as those held in the Invesco QQQ Trust (QQQ). Cumulative performance for the tech-heavy ETF is 45% above that of the SPDR S&P 500 ETF Trust (SPY). Compared to the iShares Russell 1000 Value ETF (IWD), it has outperformed by 67% in the same time span.

 

Chart courtesy of StockCharts.com

 

For investors who want to take equity risk off the table but aren’t compelled to trade in that exposure for interest rate or credit risk, there are strategies that use options to change the risk profile of this growth stock exposure.

Creating The Collar

The Nationwide Risk-Managed Income ETF (NUSI) is one such strategy. Similar to a covered call strategy like the Global X NASDAQ 100 Covered Call ETF (QYLD), the fund invests in the stocks of the Nasdaq-100 and sells out-of-the-money call options on the index in order to generate income.

This feature means the fund has a significantly higher yield than its option-free counterpart. The distribution yield for NUSI is 5.0% versus just 0.5% for QQQ.

In addition to writing out-of-the-money calls, the ETF uses some of this premium generated to buy a protective put. This limits the downside potential for the fund. The payoff profile looks something like this:

 

Pop-up Image

(For a larger view, click on the image above)

 

NUSI uses a protective net-credit collar strategy. This means that the premiums received from writing the calls are higher than the premiums paid for purchasing the put.

Similar But Different

If this sounds similar to defined outcome ETFs, it is. In fact, FactSet classifies NUSI as such a fund.

But rather than having a specified cap and buffer like other defined outcome ETFs, NUSI actively manages its options holdings. This means that in strong up markets, the call options may be closed early to minimize potential losses.

The fund does not have an annual outcome period like most defined outcome ETFs either, instead rebalancing on a monthly basis.

In a strong up market like the one we’ve experienced since equity market lows in March 2020, NUSI has significantly lagged QQQ. However, this underperformance is to be expected given the limit on upside potential due to the writing of the call option.

 

Chart courtesy of StockCharts.com

 

Looking at the more volatile environment in February and March shows how NUSI can provide protection in down markets. NUSI lagged QQQ’s ascent in the first three weeks of February but protected against the downturn in March.

 

Chart courtesy of StockCharts.com

 

How To Use NUSI

While equity or fixed income funds often have a clear use case, NUSI can be used in several ways depending on the client’s needs.

One rationale for use of this ETF is the higher yield. With the S&P dividend yield at 1.3%, the 10-year U.S. Treasury yield at 1.3% and the ICE BofA U.S. High Yield Index Effective Yield at 4.2%, income-sensitive investors have limited options when it comes to generating yield. NUSI can be another tool in the income toolbox.

The ETF can also be an option for those who want to maintain some exposure to the high-flying growth names that have been significant beneficiaries of the “stay-at-home” trade, as long as they are willing to give up some of the upside for protection from the downside. The ETF could be paired with QQQ to temper volatility or used in its place for a less volatile option.

It could also be seen as a type of bond proxy, enabling investors to take equity risk off the table with the benefit of not taking on interest rate risk. Year-to-date, NUSI has outperformed both the iShares Core U.S. Aggregate Bond ETF (AGG) as well as the iShares iBoxx USD high Yield Corporate Bond ETF (HYG).

 

Chart courtesy of StockCharts.com

 

Funds that use options are complex and can be difficult to understand, but they can also be a source of risk management and diversification for your portfolio.

When it comes to more volatile areas of the market such as that represented by the Nasdaq-100, funds such as NUSI offer a safer way to gain partial exposure to this space while limiting downside risk.

Contact Jessica Ferringer at [email protected] or follow her on Twitter

Find your next ETF

Reset All