In recent weeks, I’ve been reviewing income investments with the goal of selecting assets for a portfolio that will produce current income in the 7% to 8% range and have a high degree of capital preservation over time. The portfolio is intended for a new retiree, so capital safety and sustainability takes priority over unsustainably high income. I first described the goals and objectives in March (FOF: Building A Sustainable Income Portfolio) and have been slowly adding suitable prospects (listed here).
Most recently I diverted to consider several option-based funds, notably the Eaton-Vance option-income closed-end funds. Then in response to readers’ queries following that article, I examined the covered-call fund Global X NASDAQ 100 Covered Call ETF (QYLD). Another fund readers have been asking about is Nationwide Risk-Managed Income ETF (NYSEARCA:NUSI). Both QYLD and NUSI start from the same place. The holdings for each replicate the NASDAQ 100 Index (^NDX) and they write index options on those holdings.
As a quick aside let me note two points. One, I will sometimes use QQQ to represent the index as it is the investable form of the index. I am, of course, aware that QQQ is not the index; pointing that out really isn’t a particularly powerful argument to support any disagreements you may have with whatever I say. And second, I'll remind readers that index options work differently from options on stocks. They are always cash settled. So readers who are familiar with equity options - for example, selling covered calls - should be aware that when an index option expires in the money, it is not settled by transferring the underlying asset; it is settled by cash payment.
How NUSI Is Different from Covered-Call Funds
Both NUSI and QYLD hold the portfolio that comprises the NASDAQ 100 index (^NDX). QYLD is strictly a covered-call fund. It writes at-the-money calls to settle the following month. The calls cover 100% of the notional value of the portfolio. I am not absolutely certain, but it seems that the fund routinely holds those calls until they expire.
NUSI is a very different option-based fund. It uses a collar strategy. That is, it writes calls (at 100% of notional value) and buys put (also at 100% of portfolio value). Both legs of the collar are written out of the money. Management may at times exit one, or possibly both, leg(s) before expiration. Furthermore, both options are out of the money.
The collar strategy is fundamentally defensive in that it limits losses (via the long puts). It differs from simply buying protective puts by selling calls to generate a premium that covers the cost of the puts and can provide some income as well. In NUSI’s current implementation and, I assume, as a regular strategy, the premiums are sufficiently out of the money to allow a meaningful credit from the call premiums while still leaving room for capital growth in the portfolio's holdings before strike is reached.
NUSI's Current Option Portfolio
For example, let’s look at the current option positions for NUSI. On 16 April, the previous month’s options expired and NUSI opened new positions. At some point during that month (I could not glean when as I did not follow the portfolio changes on a daily basis), the protective put was closed. The option-month expiring 16 April saw a near 10% gain in ^NDX, so closing that put while it still had some (likely minimal) time value remaining was reasonable. There is no record of the actual credits and debits for the option transactions, but we do know the strike prices and can estimate those costs. The following analysis is based on closing prices for 16 April and midpoint pricing for the options on that date. They are not actual values for the fund's trades, but should be reasonably close.
The index closed at $14,042 on 16 April. NUSI opened the two legs of the collar at 202 contracts, >99% of the notional value of the fund’s equity holdings, with a 21 May strike date. The long put leg has a 12,600 strike (10.3% OTM) and the short call leg was written at a 14,425 strike (2.7% OTM).
I estimate the net credit to be $8,160.82 for a single contract pair, generating a credit of $ 1,648,486 for the 202 contract pairs.
The net result is if both legs are held to expiration, the maximum gain (premium credit + capital gains up to the 2.7% cap) is $9,386,940. The maximum risk (capital loss to -9.7% floor minus premium credit) is $27,478,060, nearly three times the maximum gain. Essentially what this collar does is protect against a catastrophic loss of more than 10% in the month, while collecting gains up to 3.3% if the index gains 2.7% or more.
This chart (from OptionsForProfit’s calculator) summarizes the collar at the time it was opened (16 April).
How Likely Are NUSI's Cap and Floor Prices?
To get a sense of how likely the cap and floor for this current collar is, I calculated the distribution of monthly changes for QQQ, the investable index ETF. QQQ’s percentage changes should vary only trivially from those of the index, sufficiently trivially that they can be ignored for our purposes. I did, however, use calendar months, not option months (third Friday to third Friday). That difference is much less trivial, but a much more accessible dataset. So, the general shape of the distribution should be similar but actual values will differ, perhaps considerably at times.
This chart shows the percent of time QQQ turned in a monthly percentage return at or greater to a given level.
This second chart is a frequency histogram of the distribution of monthly percentage gains and losses.
The maximum monthly loss sustained by QQQ is -8.92%. It is, of course, possible that a -10% loss had occurred for an option month at some point, but that is certainly an event with so little likelihood that few would regularly choose to incur the cumulative cost of insuring against it. I do not have access to any historical data on NUSI’s option-investing history, but I find it unlikely that they are regularly purchasing 10.3% OTM puts. I expect that NUSI’s management team has a strongly bullish view of NDX’s prospects for the current option month. They are committed to a monthly collar strategy, but that bullish view may have led them to select an unusually deeply out-of-the-money floor this month. I simply don't know and would welcome any input from any reader who has some insight into this question.
The short call option at 2.7% OTM is a different story. A 2.7% monthly gain is QQQ’s 55 %tile. Thus, 45% of the time there will be a cost for the call premium (again, extrapolating from calendar month values). Adding the credit from the premium moves the gain to the 63 %tile.
My view is that a cap that will be participating in all gains in all but 37% of the time is a reasonable collar strategy on the covered-call leg. If I held the fund I would be pleased to think that this was a routine target for the collar’s cap.
Compare this to QYLD’s implementation of its option strategies. QYLD routinely writes covered calls at the money. While this secures high premium, it eliminates any possibility for capital gains. The strike selection for the calls is formulaic. There is little management input regardless of their view of the expected outcome for the coming weeks. NUSI’s management not only has the flexibility to base the collar on their expectations of market behavior, they also can close a leg of the collar prior to the strike date when that is deemed to be advantageous.
How Has NUSI Performed?
This strategy has produced a 7.9% dividend yield. Monthly payments have been reasonably consistent at 0.65-0.66% TTM.
Fund inception is 19 Dec 2019, so there’s not a lot of history to look to. But it does include the COVID-crisis downturn, and the bullish recovery and post-election period, which can give us some insight into how the fund may be expected to perform in adverse and favorable market conditions. This chart shows NUSI’s total return (dividend reinvested) and price (capital value after distributions) since inception. I’ve compared it to the two major market index ETFs (QQQ and SPY) as well as the popular option-income ETF, QYLD.
We can notice several key events here.
First, NUSI did fulfill its objective of downside protection in the COVID-crisis drawdown. This is, by any measure, an impressive demonstration of the power of the collar strategy in difficult market conditions.
Second, as expected, NUSI fails to keep up with the equity index funds in the bullish stage of this period. Its total return pales in comparison to QQQ, whose portfolio it replicates, showing the downside of the collar strategy. It looks stronger here vis-à-vis SPY but that is largely carryover from the outstanding performance during the drawdown period. Once SPY’s recovery caught up to NUSI, it kept moving past it. Again, just what one might have predicted for a collar strategy in bearish and bullish times.
Third, QYLD, despite a four percentage point advantage in distribution rate, lags NUSI throughout. Total return, which normalizes for distributions and dividends across funds, is especially telling with NUSI coming in 9.5 percentage points ahead of QYLD. QYLD’s covered-call strategy means it falls with the index ETF in the downdraw and the ATM cap inhibits a strong recovery.
PortfolioVisualizer gives us a nice data summary of the charts' trends.
Obviously, neither of the option funds can begin to keep up with QQQ over this extraordinarily bullish period, but let’s compare them to each other. Start with CAGR. NUSI’s is twice that of QYLD, which generated 10% greater return since NUSI’s inception. Volatility (as StDev) strongly favors NUS over both ETFs, as does best and worst year metrics.
Maximum drawdown is interesting. QYLD sunk deeper than even QQQ, while losing twice the fraction of its peak value than NUSI did. Also interesting is that NUSI’s maximum drawdown did not come in the depths of the COVID crisis. It was in the autumn of 2020 during the pre-election period of market uncertainty.
(Blue = NUSI , Yellow = QQQ, Red = QYLD)
Correlations with Other Asset Classes (ETFs)
Finally, here’s a look at how well NUSI plays with others.
In the discussion of QYLD, the subject of correlation was a topic some chose to debate, so I thought I’d include it here as well. NUSI is, as one has to expect from its portfolio, relatively highly correlated with QQQ. Less so, however than QYLD. So in a portfolio, either fund will be behaving as an equity fund, which is, of course, what they are.
NUSI is a strong candidate for the Sustainable Income Portfolio. It has delivered a consistent 7.9% while tamping down volatility and gliding over the deepest drawdown in equity markets since the Great Recession. In its short existence it has gained capital value after paying out that 7.9%. The fact that its record encompasses both adverse and strong market conditions bodes well for its future prospects.
I would like to have a better picture of how variable its collar implementation is. It’s doubtful that it was buying deeply OTM puts during COVID crisis period; the excellent performance during that drawdown attests to that. I’ll try following the fund’s picks for a few months to bring some clarity to that point.
Overall, I find there’s a lot to like here and will almost certainly be recommending NUSI for inclusion in the portfolio.