On a number of occasions over the past — I don’t know — call it six or so months, I’ve mentioned the ballooning AUM of yield-enhancement/derivative-income products.
These come in different flavors, none of which are particularly appealing to me, but what do I know? That’s not necessarily sarcasm. Every day offers some new reminder that I’m bereft in one sense or another. And every day I’m comforted by the notion that the wisest man in human history famously knew nothing.
One thing the marketing gurus at ETF houses apparently know is that a lot of investors don’t believe they can pre-fund their post-career lifestyles with cash income, even when term deposit rates and government money fund yields are the highest in two decades. Hence the rise of call-writing products, which’ve “been a fat pitch to the aging demographic who know they can’t retire on money market returns alone,” as Nomura’s Charlie McElligott wrote Tuesday.
The idea is to retain exposure to equity upside even as you accept a cap on that upside in exchange for income (i.e., the premium you earn from selling calls).
The figure above will look familiar. AUM is now north of $60 billion for these products, and the mainstream financial media ran at least a couple of pieces in 2023 highlighting the explosive growth.
Of course, the associated flows don’t exist in a vacuum. They’re impactful. And increasingly so. “Option-based ETFs have emerged as another new, material source of volatility supply in recent years [with] the strong growth of call overwriting ETFs delivering significant gamma to the Street,” JPMorgan analysts including Marko Kolanovic wrote. “Based on the current AUM of overwriting-based ETFs, if we simplistically assume they are all systematically selling 1-month 30-delta calls on their full fund notional, they would be supplying on the order of ~$6 billion of gamma each month.”
That’s part of the ongoing vol-suppression regime which McElligott has highlighted and discussed again and again. “Short vol flows continu[e] to hammer index vol from systematic volatility risk premia strategies, overwrite/underwrite funds and ETFs, along with the usual suspects from QIS-, exo- and dispersion- spaces, stuffing dealers on long gamma and preventing outlier moves via the insulation,” he said.
When it comes to the ETFs, market participants are starting to pay more attention to the rebalance, where “more attention” means they’re front-running it. Bloomberg ran a short article on that phenomenon last month. It quoted McElligott.
On Tuesday, he again set about explaining the implications for these call-selling products of a market melt-up. “As we’ve seen time and time again this year, the calls are continually being stopped-in and mechanically forced to cover on their rebalances,” he wrote. “These funds then squeeze the tape as they buy back the ITM calls they sold and dealers are then left with beaucoup delta (futures) to buy as their hedges are unwound.”
As noted, “efficient” markets have learned to front-run this, as illustrated rather poignantly by QYLD, the ETF mentioned in the linked Bloomberg piece. Headed into in-the-money unwind weeks for the product, the Nasdaq 100 tends to notch “large outlier median returns,” as McElligott put it.
The figure above gives you a sense of things. It also shows what can happen when the position is reset (i.e., the red-shaded cells in the “day of new call sell” column).
Writing last month, Bloomberg’s Jan-Patrick Barnert, citing Charlie, described the dynamic in layman’s terms. “Since January 2022, there have been seven occurrences where [QYLD] had to unwind calls that where at last 105% in-the-money,” he wrote. “The last six of them have all seen the Nasdaq trade higher the week into the cover of the position with an average return of 2% over the week.”
As to whether these products have served their purpose (i.e., if they’re beating out cash and otherwise making folks happy despite the annoying tendency for equities to melt-up through the associated call strikes), the answer is apparently “yes.”
“Once you add back the income generated, the total returns for many of the largest products in this universe are indeed clearing meaningfully above cash,” McElligott said Tuesday. “Mission accomplished!”
Nice graphic.
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So what is the downside risk to these kinds of ETFs?
The same as if you sold a covered call. You are still long, so you will lose money if the market goes down, and you sold a call, so you will make a lot less money than you could have if the market goes up.
Yep. You’re trading a bit of extra safety/a few points of downside protection against the upside…
I am not convinced it’s great on a systematic basis b/c missing the great bursts upwards (say, November this year) seem too deleterious to long term perf/compounding…
On a non systematic basis, you can argue it’s an attempt at market timing with all the associated proofs it doesn’t work but I prefer to think of it as conditional profit taking… 🙂
Thanks for keeping us informed about these things. Seriously.
But …. uh … aren’t the movement in stock prices merely in response to changes in EPS outlooks? (Sour old man speaking. But I would have loved this market 40 ears ago.)
Gotta love Plato!
Socratic
Got to love optics for the writing calls ETFs. They all look great until they don’t!
Excuse me for being naive—so under the right conditions you could have a market melt up monthly?
Looking at 2, 5, and 10 year total return charts for QYLD, I do not understand why one would own this ETF.
When I was a young pup I hated stocks except for their value in writing covered calls. My main investments were in the bond carry trade, but I always had 5 or ten covered calls open at any time. These days I let others manage the leverage, buy steaks when I want with my cash and skip the call writing. My office mate in my doctoral program was a 19 year-old Finance PHD student who was an expert option trader. Of course, at that time (the late 1960s) there was no organized option market. Every contract bought or sold was executed at a negotiated price through a market making OTC broker-dealer. My mate worked the country from NY to Cali on the phone all day. The students adored him. He was the Pied Piper with near a million of his own money. He wrote his ~1000 page dissertation on the options market, analyzing which derivative strategies offered the best returns. Covered calls way outshined the rest.