An Options-Based ETF Strategy to Generate Income, Manage Downside Risks
January 30, 2020
ETF Trends – By Max Chen
Fixed-income investors who are struggling with yield generation in a low-rate environment should take a look at a new risk-managed income exchange traded fund strategy that could generate improved yields relative to traditional income-focused investments.
In the recent webcast, Dynamic Strategies for Generating Income While Managing Risk, Mark Hackett, Chief of Investment Research, Nationwide, highlighted the increased demand for fixed-income assets, especially as a safe-haven play. However, income investors face increased trouble with finding attractive yield-generating strategies as the steady decline in Treasury yields has made it exceedingly more difficult for investors to generate reliable streams of income from traditional bond investing.
Consequently, Jonathan Molchan, Executive Director and Portfolio Manager, Harvest Volatility Management, pointed out that investors are increasingly taking on greater risk in search of attractive yields. For example, more
“In the midst of a persistent low-rate environment, investors and advisors alike have increasingly sought out several alternatives to traditional bond investing as a means to generating supplemental income,” Molchan said. “These alternatives include high dividend stocks, REITs, emerging market debt, high-yield bonds, preferred stock, and MLPs.”
Molchan warned that these alternative income-generating ideas come with risks or tradeoffs such as interest rate sensitivity as well as risks associated with duration, inflation, commodity exposure, and leverage.
Consequently, Nationwide recently launched the Nationwide Risk-Managed Income ETF (NYSArca: NUSI) to help investors target high current income with less risk relative to traditional income-focused investments.
“NUSI is a new addition to these popular income-generating strategies,” Molchan said. “NUSI targets high monthly income with less risk relative to traditional income-focused investments. It seeks to provide investors with a measure of downside protection with potential upside participation.”
The Nationwide Risk-Managed Income ETF incorporates options exposure to help generate income and mitigate risk as a way to enhance total returns. Investors have long capitalized on covered call options strategies for income generation or protective put options strategies to protect against and limit losses.
NUSI incorporates both covered call and protective puts as a way to enhance income generation and protect against any potential downside.
A covered call refers to an options strategy where an investor writes or sells a call option on an asset which they already own or bought on a share-for-share basis to generate income via premiums derived from the sale of the call options. However, the covered call strategy caps upside potential and provides limited downside protection, so it is ideal for investors with a neutral-to-bullish outlook.
A protective put is an options strategy where an investor purchases a put option on an asset which they already own or bought on a share-for-share basis to limit potential loses. The protective put will cause profits derived from the strategy to be reduced by the premium paid for the put, but it limits the maximum potential losses. A protective put strategy is ideal for investors with a bullish outlook who wish to hedge a long position against a downturn.
“Through the combination of income generation and downside protection NUSI can benefit investors and advisors as it’s a solution that can complement a traditional 60/40 allocation and it can be used as a bond alternative that can afford investors flexibility across varying market cycles. In addition, NUSI can be a volatility dampener that may augment existing allocations as well as a tool that may aid in supplementing current income,” Molchan said.
NUSI follows a three step strategy. First, it fully replicates the constituents of the Nasdaq-100 Index. Secondly, the ETF deploys a rules-based options collar strategy that combines a covered call and a protective put. FOr the covered call component, a near-at-the-money to out-of-the-money Nasdaq-100 Index call option is sold, with the intent of generating options premium. For the protective put component, the strategy uses a portion of the options premium received to purchase an out-of-the-money Nasdaq-100 Index put option, which seeks to fully hedge the portfolio below current market price and protect against potential losses in the equity portfolio.
Finally, a monthly distribution is paid out using a portion of the net-credit generated by the collar. If there is remaining options premium, the ETF will reinvest in the underlying stocks for potential upside participation.
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