Building An ETF Future On Options Strategies

Building An ETF Future On Options Strategies

In a bond world turned upside down, thoughtful ETF options strategies may not seem so scary.

Managing Editor
Reviewed by: Olly Ludwig
Edited by: Olly Ludwig

Recon Capital Partners, the Greenwich, Connecticut-based exchange-traded fund firm, sees a bright future for ETF strategies that use options. It already has one fund on the market, the $20 million Recon Capital Nasdaq 100 Covered Call ETF (QYLD | C-45), and it envisions a future with plenty more, particularly once the Federal Reserve has begun raising rates.

The company recently filed for permission to self-index many of these strategies. Recon’s Chief Executive Officer Garrett Paolella said it was a signal that the young ETF firm wants to stay ahead of the competition and customize methods of extracting incomelike streams from equities in the form of covered-call strategies and cash-secured put strategies.

To put the company’s plans in perspective, consider that a covered-call fund like the market-leading $313 million PowerShares S&P 500 BuyWrite Portfolio (PBP | A-67) produces a return profile that, over time, is like a portfolio composed of 60 percent stocks and 40 percent bonds. Paolella argues that sort of predictability is reason enough to make him confident that investors who have been reaching for yield in long-dated debt or in junk bonds might find an options-based equity strategy comforting once the Fed gets started and the bond market turns volatile. Why file for self-indexing?

Garrett Paolella: To continue to bring transparent, liquid products to the marketplace in the form of ETFs. We have some internal strategies and things we would like to get out into some filings without having to pass off the intellectual property to another index provider. Are you able to discuss some of those? Or are you keeping the intellectual property close to the vest?

Paolella: I can't really talk about all that yet. But QYLD is a great first start, but we're looking to leverage that and add on to that so investors will be able to get a high rate of income without interest-rate or duration risk by using other option strategies. Tell me about QYLD.

BXN is the Nasdaq-100 covered-call index that we licensed from Nasdaq, and QYLD is designed around the BXN. We'll come out with our proprietary underlying equity indexes and we’ll be doing overlay strategies, whether using covered calls or cash-secured puts and doing different facets. But they won’t be as generic as, say, PBP, which sells front-month S&P 500 Index call options that are at-the-money. Are these funds income-replacement strategies that will be available when there’s a secular bear market in bonds?

Paolella: Yes, and there are two reasons why we like what we're doing. The one we lead with is that there are now 7,000 baby boomers a day maturing into retirement and looking for cash flow. And when you look at the various asset classes, yields are at all-time lows, bond prices being where they are.

And if you can use options in an efficient manner to either mitigate risk or to enhance income for a portfolio, regardless of whether it's institutional, retail, we see a great space in ETFs where you can package simple options-based strategies for clients to both mitigate risk and gain income in ways they're not able to get that right now—or if they are, they're stretching for yields in junk bonds or high-yield markets to take on more risk or leverage to be able to get that kind of income. All this talk about covered calls and cash-secured puts does make sense, but you and I both know that, in many quarters, all you have to do is say the word “options” to inspire fear. How do you deal with that?

Paolella: Well, options aren't a new asset class. So when we talk to advisors or investors, it's not so much that this is a new thing, it's just teaching, like: “This is a very systematic and simplistic way to augment income in your portfolio. It's there to add in an additional income source that you're not getting—and in a tax-efficient manner.”

As for QYLD itself, it's tracking an index that's been out there for 20 years, and you can see the history and the performance of the actual index. That gets advisors and even investors more comfortable with what we're doing. And I presume the other case you have to make is to point to a wonderful bond fund like the Vanguard Total Market Bond ETF (BND | A-94) and argue owning that could be a quick step into an abyss of capital losses in the next 20 years. It could be distressing if you’re about 65 years old when the Fed starts raising rates, right?

Paolella: Yes, of course. And with QYLD, you're getting the exposure to the Nasdaq-100 Index with some additional income and lower volatility for not a lot more in price. Talk about the structure of an ETF like QYLD. It's relatively streamlined compared with what you would be dealing with if you had perhaps a single-stock option, right?

Paolella: That's right, because a single stock option could be exercised against you. And it also would call the shares away from you. In this case, if we needed to raise cash, we'd sell shares of the underlying securities within the portfolio and settle it for cash. But the market has to move more than the strike plus premium to offset that expense. What's the potential of this marketplace? Your QYLD has $20 million and PowerShares’ PBP has $313 million. It’s early days, but what is the opportunity, and when might it start to manifest?

Paolella: I think it's a great space to be in. A lot of clients have been kind of playing the long-only game, given the amount of monetary stimulus that's been in the market. As I mentioned before, some clients have been reaching for yield in high yield. So as interest rates start to rise, you’ll see a lot more volatility and downside risk in fixed-income portfolios.

So I think there's a big opening for us to bring out more income-alternative, lower-volatility products for the next five years. And doing that in a tax-efficient ETF structure is giving those clients another way they can go get some income where they don't have that interest-rate risk or duration risk that they now have in their fixed-income portfolios. Do you envision a sort of slow and methodical series of product introductions, or do you imagine you might say: “Now's the time,” and flood the zone with four or five strategies that people can really get their heads around?

We definitely take more of a rifle approach at launching products than a shotgun approach. We are very streamlined in what we're looking to come out with in future products. And I think the marketplace dictates some of that, but it's really a long-term vision for us. So I would still like to see us come out with a few more filings for this year. I would say probably around maybe three filings for some of our future options products.

Olly Ludwig is the former managing editor of Previously, he was a financial advisor at Morgan Stanley Smith Barney and an editor at Bloomberg News. Before that, Ludwig was a journalist at the Reuters News Agency in New York.