How to determine whether you should invest in a complex investment such as an actively managed ETF that uses option strategies.
Topics covered include:
- A recent investment David made that he shouldn’t have
- What is the volatility risk premium and how to invest in it
- Why there have been over 200 new ETFs and ETNs launched in the U.S. in 2020
- Why some ETF sponsors launch lower cost versions of ETFs that compete with their existing offerings.
- What questions to answer as part of analyzing a complex investment
- Why there is always a catch to ETFs such as the Innovators Stacker and Ultra Buffer ETF series that can make them seem too good to be true.
- A simpler way to lower portfolio risk without using complex option-based ETFs
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Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today’s episode, 321. It’s titled “How to analyze complex investments.”
Volatility Risk Premium and Carry Trades
Last November I purchased a small position in the Guggenheim Enhanced Equity Income Fund. The ticker is GPM. This is a closed-end fund that seeks to harvest what is known as the volatility risk premium. The volatility risk premium represents the compensation that investors receive for bearing the risk of higher volatility and market losses. In other words, investors receive income for being willing to help other investors protect against losses in (let’s say) the stock market.
This is usually done by selling call or put options. It’s an example of a carry trade. A carry trade is an investment strategy that earns income as long as nothing happens. And by nothing changing, in the case of this particular closed-end fund, the stock market doesn’t fall.
We discussed carry trades in episode 283 of the podcast. I could take up the entire episode explaining option strategies in this closed-end fund, but that isn’t really today’s topic. It’s about the principles of analyzing complex investments, some of which employ options. When it comes to investing, I have a built-in filter that keeps me from purchasing investments I probably shouldn’t. And that filter is I have to explain to over a thousand Plus members why I made that particular investment, and how it works.
I share my entire portfolio and all my holdings, and when I make a trade, and so knowing I have to explain it sometimes keeps me from purchasing a particular holding. Although it didn’t in this case. You can have a similar filter in your investing. I discussed it in my book, “Money for the rest of us. Ten questions to master successful investing.” The first question is “What is it?” We should be able to explain to a friend or family member a particular investment before we invest because doing so helps us realize what we may not know. It humbles us. This particular investment that I made in the Guggenheim Enhanced Equity Income Fund was an experiment, and I made it clear on the Plus member website that this is risky. It’s experimental.
But within a couple of days of making the investment, Drew, a member of the site, kindly questioned me on the Money For the Rest of Us Plus member forums as to why I had made this investment. He pointed out a number of items. One, this is a closed-end fund. Closed-end funds have very high expense ratios. There’s a free investment guide on MoneyForTheRestOfUs.com on how to invest in closed-end funds.
I knew that this was an expensive fund, but I thought it had attributes that more than compensated for that. The second point he made was the large amount of leverage that this particular closed-end fund used. It invested about 150% of net assets in the equal-weighted S&P 500 index, and also ETFs that invest in the Russell 2000 and Nasdaq 100. Then the closed-end fund would sell or write call options on the Russell 2000 and Nasdaq 100. This was effectively a covered call strategy with leverage.
By writing or selling call options, the closed-end fund was receiving premium income, and then it participated in the upside of the S&P 500, but it had the downside of 150% of the stock market. And that was sort of the challenge with this closed-end fund. It was risky.
When we look at what happened this year, this particular closed-end fund lost 50% during the market downturn. Whereas plain vanilla covered call strategies such as the WisdomTree CBOE S&P 500 PutWrite Strategy ETF, which I also own—that was only down 28%.
I sold this particular closed-end fund five days after I bought it. It’s a little embarrassing to admit that I made a mistake. I shouldn’t have bought it. I should have better understood the risk. I spend a lot of time analyzing different investments—for Plus members, for my own investments—and it’s something as investors we’re going to have to get better at. Because, as I discussed in episode 277 of the podcast, about recent changes that the U.S. Security Exchange Commission made, that would lead to a proliferation of ETFs. There are going to be many more ETFs than there have been.
A Proliferation of ETFs
In 2020 alone there have been over 220 new exchange-traded funds and exchange-traded notes launched. The reason why is that the SEC now allows for actively-managed exchange-traded funds. Previously, most ETFs were passive; they were seeking to track a specific benchmark or index. Now they don’t have to. They can be just like an actively-managed mutual fund, except it’s in exchange-traded fund form. You don’t get as much transparency with an actively-managed ETF as you do with other ETFs.
There have also been regulatory changes where it’s easier for ETF sponsors to launch an ETF, so we’re seeing a lot more of them. Some of them are a little gimmicky.
If we look at the ETFs that were launched, there’s this SOFI Weekly Income ETF (TGIF). They say they’re going to pay income weekly, and you get to pay 0.6% for that weekly income, which essentially is a bond ETF. It’s buying investment-grade and non-investment grade bonds.
It’s a clever ticker symbol, TGIF, but do you need an ETF that promises to pay weekly income? Because ETFs receive income all the time if they’re invested in bonds and stocks.
Some of the new ETFs are very political. There’s the American Conservative Values ETF. The ETF website says the fund is actively managed and seeks to avoid ownership of companies that the advisor determines disproportionately support liberal causes, charities, advocacy groups, campaigns, candidates, PACs, and think tanks.
This ETF is going to charge 0.5% to effectively own the S&P 500 but exclude companies it wants to boycott, including Facebook, Johnson & Johnson, Walt Disney Company, Walmart, Progressive Insurance, Wells Fargo, Twitter, among others.
If you want to invest more liberally, there’s the Demz Political Contribution ETF (DEMZ). This particular ETF invests in those S&P 500 companies where the companies and their management give at least 75% of their political contributions to Democratic candidates and political action committees.
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