SPD: S&P 500 Index Fund With Extreme Downside Protection

Summary

  • A subscriber asked for my thoughts on SPD.
  • SPD invests in the S&P 500 index, and buys cheap put options to profit from extreme downturns.
  • An overview of SPD follows.
  • This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »
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The Simplify US Equity PLUS Downside Convexity ETF (NYSEARCA:SPD) invests in the S&P 500, and buys cheap OTM put options for downside protection.

SPD's returns will mostly track those of the S&P 500, with some important differences:

  • SPD underperforms when markets move up, sideways, or slightly down, by about 2% per year.
  • SPD matches the performance of the S&P 500 when markets are moderately down, think 10%.
  • SPD significantly outperforms when markets are massively down, think 50% or more.

Although the fund seems like a reasonable choice for investors wishing to profit from extreme downturns, I'm not sure that this is a common or worthwhile goal. Downside protection during smaller downturns seems sorely lacking.

SPD might make sense for investors looking to profit from extreme, and only extreme, downturns, while achieving market-average returns otherwise.

Investors looking for more consistent downside protection could consider the TrueShares Structured Outcome ETFs, covered here, or the Innovator Defined Outcome ETFs, covered here.

I also went through other hedge ETFs here.

SPD Overview

SPD is a surprisingly simple fund. The fund invests 98% of its assets in the iShares Core S&P 500 ETF (IVV), a low-cost S&P 500 index fund.

So, SPD is mostly a simple S&P 500 equity index fund. SPD's long-term returns will closely track those of the S&P 500. This has been the case since the fund's inception in late 2020.

Chart
Data by YCharts

SPD invests 2% of its assets in S&P 500 put options. These options are all that differentiate SPD from the average S&P 500 equity index fund.

These same options give the fund the right, but not the obligation, to sell shares of the S&P 500 index for around 50% of its current price at a later date. Profitability depends on equity prices.

If equity prices go down by 50% or more, then the options can be profitably exercised. This is done by buying shares in the S&P 500, whose price just collapsed, and selling them for the predetermined strike price, which is higher than the (now collapsed) price. Lower prices means higher profits.

Let's have a quick look at how the above might look in practice.

SPD's largest put option position is the following:

(Source: SPD Factsheet)

Here is how to interpret the above.

SPD has an option allowing the company to sell shares in the SPDR S&P 500 Trust ETF (SPY) for $210 per share on September 2022. If SPY drops by a lot, let's say it drops to $200 per share, then the options can be profitably exercised. The fund would simply buy shares in SPY for $200 (market price), sell them (through the option) at $210, and pocket the $10 spread.

SPD has bought several different put options, all with slightly different characteristics, but they are all quite similar to the one above.

The S&P 500 has not come even close to $200 per share since SPD's inception, and so I can't really show how the fund would react under said conditions. Nevertheless, I was able to (very roughly) estimate some figures using fund data.

As can be seen above, SPD should significantly outperform if equity prices drop by more than 50%. In practice, I expect outperformance to be even higher than above, as SPD would be able to sell its (now expensive) options for (cheap) S&P 500 shares, turbocharging returns further.

If equity prices go up or move sideways, then the options should expire worthless. Underperformance should equal 2%, equivalent to option premiums / investment (i.e., you lose the money invested in the options - 2%). Since SPD's inception, in late 2020, equity markets have posted significant gains, and SPD has underperformed by 1.8%, as expected (roughly).

Chart
Data by YCharts

If equity prices go down by less than 50%, then the options expire worthless, but there might be some (temporary) gains along this way. As an example, let's say SPY's price collapses to $211. Technically the put option above can't be profitably exercised yet, prices still need to drop to $210. In practice, if SPY's price collapses to $210, the put options should see significant gains regardless, as the options are so close to profitability. Lots of investors would be willing to buy these options, expecting strong profits as the S&P 500 continues to go down.

SPD's managers expect to monetize these options when they are worth 5% of the portfolio, roughly equivalent to 300-400% gains. Generally speaking, gains are very small when prices are down by a little, but skyrocket as losses get closer to 50%. Profits would almost certainly be realized with +40% equity market losses, almost certainly not with single-digit losses, and the situation would be quite fluid with losses in between these two extremes.

Markets have rarely been down since SPD's inception, at least not by a lot. There was a tiny, short-lived downturn in October 2020, during which the S&P 500 was down by 7.35%. SPD posted losses of 7.24%, indistinguishable from a random movement.

Chart

Data by YCharts

Greater losses would have meant higher capital gains for SPD's put options, and for the fund itself and its shareholders.

Fund performance, considering both the put options and the equity holdings, looks as follows.

(Source: SPD Factsheet)

To reiterate:

SPD underperforms when markets move up, sideways, or slightly down, by about 2% per year.

SPD matches the performance of the S&P 500 when markets are moderately down, think 10%.

SPD significantly outperforms when markets are massively down, think 50% or more.

SPD - Investment Thesis, or Lack Thereof

SPD's most significant benefit is the fund's outperformance during extreme downturns and recessions. SPD should significantly outperform if markets are down by more than 50%, and should post some marginal gains / outperformance if markets are down by less than that.

Although the above is definitely a benefit, I simply don't think it is a particularly important or compelling benefit. SPD would only outperform during the most extreme downturns, and these are simply not all that common. Even during early 2020, the onset of the coronavirus pandemic, the S&P 500 was 'only' down 30%, and soon recovered some of these losses.

Chart

Data by YCharts

SPD only provides downside protection under the most extreme downturns, and these are quite rare. SPD's downside protection is ineffective during smaller downturns. Expect effectively zero protection during drawdowns smaller than 10%, and little protection during drawdowns smaller than 20%.

As mentioned previously, I just don't find this to be a compelling investment thesis. Investors are paying 2% in annual expenses for protection against extremely rare events, with little protection against more common downturns and recessions.

As an alternative to SPD, we have the TrueShares Structured Outcome ETFs, covered here. These offer investors stronger downside protection during downturns of all sizes, but no possibility of gains during extreme downturns.

A quick table summarizing the expected performance of these ETFs.

SPD - Conclusion

SPD offers investors the possibility of significant gains during extreme downturns, but slightly lower returns under most other relevant market conditions.

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This article was written by

Juan de la Hoz profile picture
7.02K Followers
CEF/ETF income and arbitrage strategies, 8%+ portfolio yields

Juan has previously worked as a fixed income trader, financial analyst, operations analyst, and economics professor in Canada and Colombia. He has hands-on experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs, and enjoys researching strategies for income investors to increase their returns while lowering risk.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Additional disclosure: This article was originally published to members of the CEF/ETF Income Laboratory on July 19th, 2021.

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