MW A new ETF touts 100% downside protection. Here is how it works.
By Joseph Adinolfi
While it sounds like financial alchemy, the fund relies on a relatively simple options strategy to achieve its goal
An ETF that launched on Monday touts 100% downside protection for investors who hold on to the fund, which is intended to track the S&P 500, for a full year.
It might sound like the financial-markets equivalent of alchemy. But the prospectus for the Calamos S&P 500 Structured Alt Protection ETF - May CPSM offers a relatively simple explanation for how the fund plans to eliminate downside for investors, while still offering exposure to up to 9.8 percentage-points of the S&P 500's return over the coming 12 months, before the fund's 69-basis point management fee is factored in.
The fund achieves this mix using a relatively straightforward multileg options strategy. It also comes with an important catch: investors must buy the fund on Wednesday, and hold it for 12 months, to achieve the maximum return, while benefiting from the fund's 100% downside protection.
Two key elements of the funds' strategy are high interest rates and the use of so-called "flex" options, both of which help to minimize the cost of the contracts used by the fund.
Here is how the strategy works: first, to try to replicate any advance for the S&P 500 over the coming year, the fund purchases deep in the money "flex" call options set to expire on May 1, 2025.
Flex options trade on exchanges like Cboe Global Markets, but are similar in some ways to bilateral over-the-counter options contracts due to the ability of the buyer to customize them. This differentiates them from standardized exchange-traded options. While the counterparty for most exchange-traded options is a market maker or another trader, the counterparty for these flex options is the Options Clearing Corp., the main options-market clearinghouse.
The flex options purchased by Calamos are European style, meaning they can only be exercised on their expiration date, unlike American-style options, which can be exercised at any time before they expire. This makes them cheaper, allowing the fund to secure a more advantageous upside cap for its investors while still offering 100% downside protection. But it is also responsible for the requirement that investors hold the fund for 12 months for it to function as advertised.
For a call option, being in the money means the strike price of the contract is already above that of where the underlying index or stock is trading. But since investors don't receive dividends from an option, even an in-the-money contract can trade at a slight discount.
Using in-the-money options allows the fund to more cleanly track the price return of the S&P 500 without receiving dividends, which would muddy the return cap and create unwanted tax liabilities, according to Matt Kaufman, head of ETFs at Calamos Investments.
Calamos then hedges this position by buying an at-the-money flex put option, which provides the fund's 100% downside protection. Finally, it offsets the cost of these two options by selling an out-of-the-money flex call, which caps the fund's 12-month return.
If the fund didn't include this last option leg, the strategy would be too expensive to effectively track the S&P 500.
Kaufman offered this analogy to explain how investors' money is put to work. Out of $100 dollars invested, $98 will go toward the in-the-money call. Then, another $5 would be spent on the at-the-money put. Finally, the fund will sell the out-of-the-money call to generate $3 of income, bringing the net asset value back into balance.
An at-the-money option is a contract where the strike price is on par with where the underlying security or index was trading at the time of purchase. An out-of-the-money contract is one where the strike price is above or below the current market price, depending on whether the contract is a bearish put or bullish call.
High interest rates are also critical to achieving the trade-off between the fund's potential upside and 100% downside protection, Kaufman said. Options prices are impacted by several factors, including the level of the risk-free rate of interest. A contract's sensitivity to changes in interest rates is known as "rho" in options parlance.
When interest rates climb, the cost of a put option declines, while the cost of a call option rises. As such, interest rates at their highest levels in more than 20 years are helping the fund to offset more of the cost of the protective put option while providing customers with a higher cap for potential gains. If rates were lower, investors would have to accept a lower cap on returns for the strategy to work.
According to the prospectus, the strategy will reset in 12 months' time. Anybody who sells ahead of this turnover date could be exposed to losses, depending on whether the S&P 500 has risen, or fallen, since the fund's launch.
If the S&P 500 has risen, late buyers will see less of their downside protected, along with a lower cap on gains. If the fund's net asset value - in this case, the combined value of the fund's option positions - increases significantly after its launch, anybody who buys in later could, at least in theory, be at risk of losing their entire investment, according to the prospectus.
The Calamos S&P 500 Structured Alt Protection ETF is part of a class of dividend-income funds. These funds have seen their popularity explode over the past three years, according to data from Morningstar investments.
Their appeal, according to Kaufman and Todd Sohn, an ETF and technical strategist at Strategas, is that they limit holders' exposure to losses, while allowing them to achieve stocklike returns.
"I like to believe there is a large cohort of investors - perhaps those approaching or in their retirement years - that want to invest in equities but fear a 2000 or 2008-type redux, as rare as those environments are," said Todd Sohn, an ETF and technical strategist at Strategas, in emailed commentary.
The Calamos fund was up 0.4% at $25.11 a share Wednesday afternoon, while the S&P 500 SPX was up 0.8% at 5,073. The fund is the first in a series of similar products that Calamos plans to roll out on the first of every month through April 2025.
-Joseph Adinolfi
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(END) Dow Jones Newswires
May 01, 2024 15:32 ET (19:32 GMT)
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