Options strategies aren't used very often in the exchange-traded fund world. There are only nine ETFs that regularly use options, with total assets under management of a combined $800 million—small potatoes in the $3 trillion ETF industry.
But that could be changing. Strong inflows into one options-linked ETF this year suggests investors may be taking a closer look at these products as they consider new ways to generate income and hedge against downside risk in a market that is trading at rich valuations.
That ETF with the big inflows is the WisdomTree CBOE S&P 500 PutWrite Strategy Fund (PUTW), which took in $162 million in new money this year. Total assets under management in the fund surged from around $30 million at the start of 2017 to nearly $200 million currently, a big leap for the 18-month-old fund.
Put-Write & Buy-Write
PUTW uses a "put-write" strategy, which is one of two flavors of options strategies commonly used by investors.
There's the possibility for a limitless variety of options strategies, but the most popular are the "put-write" strategy used by PUTW, and the "buy-write" strategy used by ETFs such as the $313 million PowerShares S&P 500 BuyWrite Portfolio (PBP).
Buy-write strategies entail buying a stock or index and then selling covered-call options on that position.
The investor using this strategy collects a "premium," which is the price of the option, but gives up upside in the security beyond the option's strike price.
PBP, the largest buy-write ETF on the market, describes its strategy as such:
"This strategy consists of holding a long position indexed to the S&P 500 Index and selling a succession of covered-call options, each with an exercise price at or above the prevailing price level of the S&P 500 Index. Dividends paid on the component stocks underlying the S&P 500 and the dollar value of option premiums received from written options are reinvested."
‘Naked’ Position With Put-Write
Meanwhile, in a put-write strategy, an investor typically doesn't own the stock or index in question, but sells put options on it to collect a premium (known as a "naked" position). If the security falls below the option's strike price, the investor is on the hook for those losses.
The fast-growing PUTW, which is now the most popular put-write ETF on the market, describes its strategy like this:
"The strategy is designed to receive a premium from the option buyer by selling a sequence of one-month, at-the-money, S&P 500 Index puts. If, however, the value of the S&P 500 Index falls below the SPX put’s strike price, the option finishes in-the-money and the fund pays the buyer the difference between the strike price and the value of the S&P 500 Index. The fund’s strategy of selling cash-secured SPX puts serves to partially offset a decline in the value of the S&P 500 Index to the extent of the premiums received."
Buy-write and put-write strategies can be used on any security with options. In ETFs, these strategies are typically used on the S&P 500 Index, but there are funds that use them on the Nasdaq-100, gold, silver and crude oil as well.
Underperformance As Market Surges
One reason that options-linked ETFs haven't caught on in a bigger way with investors may be because of their tepid performance. During the past several years, it simply hasn't paid to invest in options strategies in an ETF wrapper. You'd have been better off buying an ETF on the underlying index or asset without the added complexity of an options overlay.
Take the S&P 500. The index itself is up 91% over the past five years, but PBP, the buy-write ETF, is only up 36.6% in the same period.
5-Year Returns For PBP And S&P 500
That's not surprising. In a surging market, a strategy of selling covered calls will tend to underperform by giving away a lot of upside to the call buyer.
But that won't always be the case. Buy-write and put-write strategies tend to outperform in sideways and declining markets. They may even outperform over the entire market cycle, according to one recent study.
A report put out by the Wilshire Analytics Applied Research Group last year looked at the returns of five CBOE options-based indices over the past 30 years (1986-2016). All five of those indices had volatility that was lower than the equity market in the period, while two also had higher returns than the market.
The report showed the CBOE S&P 500 PutWrite index, which underlies PUTW, as having slightly higher returns and notably lower volatility than the S&P 500 during the three decades that were measured.
At the same time, the data showed the CBOE S&P 500 BuyWrite index, which is the basis for PBP, as having lower returns and lower volatility than the S&P 500.
In addition to having lower volatility than the market, the Wilshire report indicated that options strategies may lead to lower drawdowns during market sell-offs. For example, during the financial crisis period—which was the worst market downturn of the past 30 years—the buy-write and put-write indices declined by less than 40%, compared to more than 50% for the market.
Lower volatility and the potential for smaller maximum drawdowns may be something that appeals to investors, especially as the bull market stretches on, raising risks of a market slide.
Source: Wilshire Analytics
Data measures period June 30, 1986 - June 30, 2016
Contact Sumit Roy at [email protected]