Q&A With Kevin Rich And New ETF For Sophisticated Income Investors

Includes: HVPW
by: David Fry

I've known Kevin Rich since he was the lead person responsible for the creation and launching of Deutsche Bank commodity- and currency-based ETFs in 2006. These included popular DBC (DB PowerShares Commodity Tracking ETF), DBA (DB PowerShares Agriculture ETF), UUP (DB PowerShares Bullish Dollar Index ETF), and UDN (DB PowerShares Bearish Dollar Index ETF) among others. Kevin left the bank several years ago to create and launch an interesting new ETF. Kevin's new firm, Rich Investment Solutions, is the sub-adviser to a new fund off the same ALPS platform that has brought the select SPDRS series of ETFs and the Alerian MLP ETF AMLP.

Dave: So tell us about your new ETF. What is it exactly?

Kevin: Thanks, Dave. The fund is called the U.S. Equity High Volatility Put Write Index Fund, the symbol is HVPW. HVPW is an income generating fund. The fund creates income by selling 15% out-of-the-money put options every two month on a portfolio of twenty stocks. These stocks are selected by the index, which focuses on high volatility securities that also meet criteria on liquidity, market cap and sector concentration. Investors in the fund receive the income by assuming the risk the underlying equities drop in value below the option strike price. Investors also give up the upside on the equities above the income they receive selling the options.

Dave: Interesting. I don't think I've seen an ETF use put options in this way. Where do you think it fits in a portfolio?

Kevin: Right, this is the very first "put-write" ETF in the market. HVPW can be considered a substitute for a long equity position since HVPW profits when its underlying stocks increase in value. HVPW can also be considered a liquid alternative investment since it provides exposure to equities through put writing. And finally, HVPW can certainly be considered a complement to income generating funds (like dividend funds and high yield bond funds).

Dave: What would you say the investment rational is for this fund -- in other words, why own it?

Kevin: Investors in this rate environment have been reaching deeper into high dividend yielding equities and lower grade fixed income products. HVPW goes long t-bills and sells 2 month 15% out of the money puts on twenty us equity underlying stocks … so investors have 15% downside protection, diversification across twenty different underlying names, and low duration by doing 2 month options. Further, as rates increase the yield from long portfolio of t-bills will accrue to the investors. T-bills today are basically flat, but just go back to 2005 - 2006 and you saw yields around 5%.

Dave: Your fund sells options for income, is it the same as a buy-write strategy or buy-write ETF?

Kevin: HVPW is similar to the buy-write ETFs, since you are generating income and giving up the upside of the underlying equities. HVPW has the advantage over buy-writes in that it sells 15% out of the money puts, where buy-writes cannot give you a buffer on the downside.

Dave: Your fact card says the fund will distribute 1.5% six time a year, or 9% per year. Can you tell us how that will work, and how confident you are you can achieve that?

Kevin: Good question as that is a differentiating feature of HVPW. After each 60 day period, or 6 times per year, HVPW will distribute 1.5% of net assets as long as HVPW generated at least 1.5% premium during that period. So if HVPW only generated 1% in a period that's all it could distribute. If HVPW generated 4% and some options were exercised against us for a loss of, say 3%, then it would still distribute 1.5%, and some of that could be deemed return of principal from a tax perspective. Also, as a 40 act fund, HVPW will have to distribute at least 98% of capital gain net income, so if after all the distributions are made during the year, if it still has additional income it may need to do an additional year end distribution.

Dave: OK, but how confident are you the fund will generate at least 1.5% each 60-day period?

Kevin: Well, HVPW just launched and has no history, so we can only get a sense of this by looking at the index HVPW tracks. That index launched in February 2012, so in the first full year of the index it showed approximately 3% premium generated per period February 2012 to February 2013. Based on this we believe the 1.5% should be achievable, but there is no guarantee.

Dave: I assume the income from your fund will be taxed as income, right? Will investors get a K-1 or a 1099?

Kevin: Yes, we don't give tax advice, but HVPW is an income strategy, so distributions will be income or short term capital gains, not long-term gains. Investors will receive 1099's for HVPW, not K-1s.

Dave: What market environments do you think your fund will thrive in?

Kevin: HVPW should perform well in upward trending and sideway trading markets. In bear markets, because the fund is effectively short the stocks it has written options on, the fund may perform poorly. However, because each option is written 15% out of the money, the fund may perform better than the broad market.

Dave: Do you think because you select highly volatile stocks your fund has more downside risk, or "tail-risk" than, say, owning the broad market or doing a put write on the broad market?

Kevin: While we have downside risk I would not say it is more risk, because remember we have a 15% buffer to the downside on each of the twenty names. Diversifying across twenty names and the sector diversification in the index selection process also lowers the event risk, or "tail-risk "around a single name or sector. Also remember, in a stressed market where the downside risk is higher, the implied volatility will also be higher, so the premium we generate selling the options should increase. Another way to say this is the market prices the "tail-risk" into the options we sell, so we should be adequately compensated for any addition risk the find is taking on.

Dave: I know your fund just launched, but from the index you track, can you tell how often the options expire worthless on average?

Kevin: Again, that index launched in February 2012. In the first full year of the index 98 of the 120 options expired worthless, so a little over 80% of the time for that period.

Dave: Thanks so much, Kevin.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.