NUSI: Know What You're Buying When Buying Derivatives

Summary

• The stock market appears to be in a precarious position with rising volatility and growing drawdowns.
• Extreme margin debt, low liquidity, overextended speculation, rising interest rates, taxes, and a weak economy may cause a large bear market soon.
• Investors can reduce downside risk through derivative-based ETFs like Nationwide's Risk-Managed Income ETF NUSI.
• NUSI offers downside protection while capping upside potential at around 10-15% in either direction on a monthly basis.
• Income-oriented investors should not rely on NUSI's high dividend yield last year since such a yield would normally cause the fund's price to decline in a flat market.

Markets have seen a spike in volatility over the past few weeks. The Nasdaq 100 ETF (QQQ) is about 7-9% below its peak. Last year's top performers such as Tesla (TSLA) have lost around a third of their value and some small technology firms are seeing even greater drawdowns. As detailed in-depth in "VGT: There Have Never Been These Many Bearish Catalysts" and "DRIV: The Electric Vehicle Bubble Is Bursting," there is a significant possibility that this drawdown will compound.

Individual investor cash levels are at historical minimums while margin debt is nearing $1T USD (nearly twice 2007 and 1999 peak levels). Many of the new investors from last year will soon have held for over twelve months, which means they'll be able to take profits with a lower tax burden. Interest rates are rising due to inflationary forces which cannot be stopped by additional quantitative easing. The economy, though stronger, remains in a precarious position.

Even if the market has another leg higher, I believe the possibility of a 40%+ sell-off has never been as high as it is today. I say this not to incite fear, but to encourage action; reasonable and rational actions that reduce portfolio risk. Indeed, there are very few "safe" assets today and cash is not desirable considering low savings rates and rising inflation.

Investors may look toward derivative-based "protected" equity funds such as Nationwide's Risk-Managed Income ETF (NYSEARCA:NUSI). NUSI is targeted toward retired investors who seek a high-income yield with less risk. Its webpage showcases its "income risk + downside protection" opportunity. On the surface, this pitch may seem to be a "no risk high reward" investment. Particularly considering its strong performance and 7.5% TTM yield shown below:

Data by YCharts

NUSI has generated both a strong dividend, decent appreciation, and hardly experienced the sharp drawdown that occurred exactly a year ago. That said, a wise person once said "If it seems too good to be true, it probably is not true". While NUSI's strategy and performance are venerable, it would be good for investors to better understand its risks.

The Nature of The "Protective Collar"

It is wise for investors who do not understand the derivatives market to seek greater information before dipping their feet. Options are often portrayed as extremely complex which discourages many from seeking this knowledge. That said, NUSI's strategy is not too complicated.

NUSI uses what is called a "protective collar" on the Nasdaq 100 index. This means it owns the index which can be emulated through an ETF like QQQ. It also owns a "put option" which acts as an insurance policy against significant losses. Minor fluctuations in the Nasdaq 100 will still impact NUSI, but losses from a large short-term decline in the index will be capped.

In order to generate a yield, NUSI sells call options. This essentially makes NUSI an "insurance provider" for short-sellers. If the Nasdaq 100 skyrockets, as occurred last year, then NUSI's gains are capped and the excess gains go to the call-option buyer. NUSI receives a premium payment for selling these call options which are distributed as dividends.

Nationwide does not openly state the strike prices and expiration lengths of its options and it seems that may be up to its manager's discretion. However, we can get a good idea by looking at the one-month rolling return relationship of the Nasdaq 100 via QQQ vs. NUSI. See below:

(Data Source - Google Finance & Yahoo Finance)

Importantly, on any given month there should be a roughly '1-to-1' relationship between the Nasdaq 100 and NUSI as long as Nasdaq's gains or losses with within 10-15%. NUSI's gains are capped once/if Nasdaq rises over 10-15% as are its losses if the Nasdaq declines 10-15%.

The fact of the matter is that NUSI does not deliver a free lunch. If the Nasdaq 100 is flat, NUSI may pay a dividend but it will decline in value. This is important to keep in mind since it means investors are unlikely to make a profit in a flat market. This can be done through a covered-call Nasdaq 100 ETF like QYLD; however, QYLD differs from NUSI in not having downside protection.

Overall, NUSI's strategy can be thought of as a volatility dampener. If the market crashes, NUSI will only see decent declines. If the market skyrockets, NUSI will only deliver returns.

When NUSI Outperforms and Underperforms

Investors who want to gain exposure to the Nasdaq 100 without the possibility of extreme short-term losses (or gains) may want to invest in NUSI. That said NUSI's protection is short-term in nature. If there is a rapid short-term sell-off, it will cap losses. However, if there are consecutive monthly drawdowns no greater than 10-15%, then it will fall with the market. This means it would not deliver alpha in a slow-moving bear market such as that of 2000-2003 but would outperform in a rapid crash such as that of 2008.

NUSI underperforms the Nasdaq 100 during rapid rallies such as the recovery last April-August as well as late last year. NUSI's most significant outperformance occurs during sell-offs and it underperforms during most other periods. This is demonstrated more clearly in the total return ratio chart below:

Data by YCharts

As you can see, NUSI's relative performance is akin to a "long-volatility" ETF such as VXX - though with much less volatility.

There are other more complicated factors one can consider. First, if volatility levels spike, then NUSI will pay more for downside protection while generating a higher premium from call options. Thus, a rise in volatility alone will not necessarily impact future performance. However, if NUSI's managers switch to further out-of-the-money options, then a spike in volatility would be a negative factor since the high SKEW index today implies OTM options are much pricier.

Additionally, if demand for put options exceeds demand for call options (as is usually the case), then NUSI will likely lose money in a flat market. This is because it will pay more for downside protection than it will earn from selling calls. The high "put/call" ratio today indicates this may be the case.

These volatility metrics can be seen below:

Data by YCharts

Volatility data today shows that risk perception is higher than normal. Option premiums are a bit above past levels and demand for put options seems to be rising slightly faster than for call options, particularly for the further out-of-the-money options (which NUSI buys). This risk situation is not nearly as extreme as it was a year ago, but it does seem to be trending higher.

The Bottom Line

Overall, NUSI is a very interesting way for risk-averse investors to maintain a position in the equity market. That said, investors should not believe it offers both risk protection, appreciation potential, and a high dividend yield. While this seemed to be the case last year, it is only because the Nasdaq 100 rose around 40% which is extremely uncommon. The fact is that NUSI's dividend yield would normally cause its price to decline proportionally. Hence, NUSI's official SEC yield is effectively 0%. It is also worth pointing out that NUSI has a higher expense ratio of 68 bps.

During a normal environment where the Nasdaq rises 5-10% per year with a few 5-10% drawdowns, NUSI would likely underperform slightly on a total-return basis. It would also likely underperform during a flat market or slow-moving long-term decline due to implied volatility premium-asymmetry. However, during a sharp sell-off, NUSI would decline much less than the Nasdaq 100.

Considering I believe the Nasdaq 100 is headed for another sharp bear market, NUSI may offer this outperformance over the coming months. That said, I am neutral-to-bearish on NUSI since I do not believe the Nasdaq 100's bull market will extend.

Analyst’s Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.