An ETF Strategy to Generate Income, Mitigate Downside Risks

Exchange traded fund investors should consider strategies for managing risk, while generating income from some of the most innovative companies in the market today.

In the recent webcast, Income Redefined: Positioning Your Portfolio for the “Known Unknowns”, Mark Hackett, Chief of Investment Research, Nationwide, pointed out that while the S&P 500 Index has generated substantial returns since the 2008 financial crisis, periods of heightened volatility, such as the Europe debt crisis, U.S. debt downgrade, Greece default concerns, and China foreign exchange devaluation and coronavirus pandemic have contributed to quick market turns.

Hackett also highlighted some challenges that investors continue to face. For example, there is still a high percentage of Americans with no retirement savings – 12% of Americans above the age of 60 don’t have a retirement account as of 2019. Many investors trade on emotions which hurt returns over the long run –  the average asset allocation investor showed a 4.8% annualized return from 2009 through 2019, compared to the 9.6% return of a 60/40 stock/bond portfolio.

Meanwhile, Nationwide remains cautiously optimistic about the economic turn around after the Federal government did “whatever it takes” to support growth through initiatives like increased fiscal spending and aggressive monetary policies.

As a way to help investors capture the growth opportunities ahead, Efram Slen, Head of Research, Global Indexes, Nasdaq, highlighted the Nasdaq, which tracks industry disruptors  and forward thinkers, with a particular focus on technology stocks that have evolved from creating consumer products to a group of companies upon which every industry and sector have become dependent. The underlying story for the rise in the Nasdaq-100 is that the U.S.’s economic growth is shifting from capital-intensive, traditional industries, like Basic Materials and Oil & Gas, to the “new-economy” sectors, such as Technology and Consumer Services. From day-to-day tasks to social interaction, each has an important influence on everyday life.

“The fundamental data behind the NASDAQ-100 has drastically improved over the past decade despite a volatile economy and the greatest financial market collapse since the Great Depression,” Slen said.

“Earnings, the most basic number to value a company, have skyrocketed, showing maturation of the companies as they increase revenues but reduce costs. Costs have been controlled, shares were bought back, dividends have increased and P/E has contracted,” he added.

Consequently, the shift in NDX fundamentals has resulted in significant outperformance over other US large cap indexes.

Jonathan Molchan, Managing Director and Portfolio Manager, Harvest Volatility Management, also highlighted the lingering challenges of generating income in a lower for longer yield environment. On September 16, 2020, the Fed pledged to keep rates at or near zero through 2023, reinforcing the current challenge faced by investors seeking to generate reliable streams of income from traditional bond investing.

Molchan also saw more investors brace for turbulence as the presidential race heats up. In a pickup that exceeds previous races for the White House, a volatility “kink” has emerged around October and November, as investors price in an uncertain election outcome and a potentially messy aftermath.

Meanwhile, conventional safe-haven assets have lost some of their luster this year. This September marked the worst performance of “safe haven” assets during a significant equity market drawdown in over a decade.

Alternatively, investors seeking to target current income with less risk relative to traditional income-focused investments have turned to the Nationwide Risk-Managed Income ETF (NYSEArca: NUSI). The Nationwide Risk-Managed Income ETF uses an options trading strategy called a protective net-credit collar to generate income. The options strategy sells an upside call option and uses a portion of the proceeds received to buy a put option to hedge downside risk on an underlying portfolio of securities.

“In the midst of recent market disruptions, NUSI has maintained a high, stable yield profile, while simultaneously outperforming other popular income-focused investment solutions, since its inception,” Molchan said.

“Year to date, the downside risk mitigation benefit derived from NUSI’s dynamic collar, specifically the Fund’s constant, fully financed hedge, has generally contributed to a lower level of volatility, relative to other income-oriented investments,” he added.

Specifically, NUSI showed a 0.23 beta as of the end of September 2020, compared to the 0.33 beta in emerging market debt, 0.39 beta of high-yield bonds, 0.46 beta of preferreds, 0.92 beta of high dividend stocks, 0.99 beta for REITs and 1.02 beta for MLPs. As market volatility spiked in the midst of the COVID-19 pandemic, NUSI became less correlated to the market, relative to other income-oriented investments, with a corresponding decline in the Fund’s beta.

“NUSI’s fully financed hedge effectively minimized the losses experienced by investors on the worst days of the ensuing COVID-19 fueled sell-off,” Molchan said.

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. Also, NUSI can be a volatility dampener that may augment existing allocations as well as a tool that may aid in supplementing current income.

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 the 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.

Financial advisors who are interested in learning more about managing risk can watch the webcast here on demand.