By Spencer Jakab
For conservative income investors, some new funds look too good to be true. That's because they are.
Touting annual distribution rates of 50% or more, they generate cash by selling options contracts on some of the most speculative parts of the stock market. The good news is that the exchange-traded funds don't carry the risk of instant ruin that sellers of the derivatives can face. The bad news is that what sounds edgy and lucrative are new flavors of an old and often disappointing strategy.
Take the YieldMax TSLA Option Income Strategy ETF with the ticker symbol TSLY, just one letter off from that of Tesla. In addition to buying Tesla's stock, individual investors have piled into call options on the electric-vehicle company -- contracts allowing them to buy shares at a future date and a set price. TSLY takes the other side of those often money-losing options bets while simultaneously owning options that give it some exposure to any appreciation in Tesla stock. The fund's recent monthly dividend was at an annual distribution rate of 57.79%.
But since being launched last November, TSLY has declined in price from $20.44 to $11.58 on Monday. That loss is slightly greater than the amount investors received in payouts.
Meanwhile, someone who just bought and held a share of Tesla itself would have received no income -- Tesla doesn't pay a dividend -- but would have made a profit on paper of 29%. The value of any investment is its total return over time, including capital gains.
A more recently launched fund has had even juicier payouts. Defiance ETFs has launched funds taking the opposite side of short-term bets on the direction of stock indexes. Called zero-day-to-expiry options, they have surged to about a trillion dollars a day in notional value, according to Defiance. Derivatives exchange Cboe recently said that about half of the turnover in short-term options on the S&P 500 index was by individual investors.
Since options buying is seen as a sucker's bet -- and particularly very short-term options that lose value almost instantly -- Defiance's fund might seem to be profiting from others' folly. "This new ETF wins as day traders lose!" reads one headline describing them.
The first three annual distribution rates on Defiance's fund that writes put contracts on the Nasdaq-100 Index have been 67.55%, 65.78% and 60.52%.
"When I hear that, my alarm bells start to go off," says Andrew Lo, a professor at the MIT Sloan School of Management.
The profits aren't proportional to the foolishness of the bets as the headline about day traders lining fund buyers' pockets suggests. Instead, the funds' return is a function of how much people pay for future volatility minus the cost to the fund of actual volatility. Both happen to be very high. Big yields can therefore come at the expense of investors' own capital.
Lo, a veteran observer of the investing industry, ran his own option-selling hedge fund in the 1990s, CDP. It had an amazing seven-year run during which it made 41% a year with hardly any losing months by selling put contracts on the S&P 500 that would only pay off if stocks plunged. The catch? The initials stood for Capital Decimation Partners and the fund only existed on paper. Had CDP stayed "open" through the dot-com crash, Lo says it would have suffered a devastating loss.
"If you wait long enough, in the parlance of Wall Street, you get your face ripped off," says Lo.
By contrast, the funds being offered to individual investors that seem to have CDP-like returns are selling "covered" calls and puts. This means they own some collateral -- it can be the underlying stock, options that simulate ownership of a stock or index or a pile of safe securities -- that prevent the fund from having its face ripped off. That safety naturally limits actual returns, and such strategies are nothing new. They have mainly been pursued by investors hungry for a bit more income than bonds or dividend-paying stocks might provide.
"It truly is more boring than people think," says Defiance Chief Executive Sylvia Jablonski.
But it doesn't look boring, and that seems to be the point. It has helped the new funds gather money rapidly from investors who might not understand how they operate. The new funds also have a higher expense ratio than most funds in their category.
The 18 funds under the YieldMax name as of late November had gathered $1.3 billion in assets with about half of that in the Tesla options fund, according to Jay Pestrichelli, CEO of their subadviser, Zega Financial. His firm also advises Defiance's funds, which he says had about $300 million in their suite of option-selling funds. Those are impressive sums in an old and crowded category where many funds languish in the double- or even single-digit millions of dollars.
Funds with big payouts may or may not do well, but they carry an additional pitfall for less-sophisticated investors: Since their prices tend to decline over time, an investor who fails to reinvest those big dividends might see similar yields from month to month but less actual monthly income. Like TSLY, Defiance's put writing fund has seen its price fall and lagged behind the underlying return of simply owning a Nasdaq-100 Index fund from its September launch through Friday.
Generating chunky income comes at a cost. Investors need to understand that.
Write to Spencer Jakab at Spencer.Jakab@wsj.com
(END) Dow Jones Newswires
December 05, 2023 07:00 ET (12:00 GMT)
Copyright (c) 2023 Dow Jones & Company, Inc.
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