HEQT - HEQT: A Young Fund With Promising Results So Far

2023-07-25 11:41:31 ET

Summary

• Simplify Hedged Equity ETF is an options-based fund that trades S&P 500 futures and options contracts to generate income and offer downside protection.
• The fund's approach is similar to NUSI but uses a different strategy of buying layers of put spreads instead of buying puts, which is cheaper.
• Despite being a relatively new fund, it has outperformed S&P 500 and NUSI during its short existence, but its low dividend yield may deter some investors.

Simplify Hedged Equity ETF ( HEQT ) is another options-based fund by Simplify which is mostly known for ETFs such as SVOL ( SVOL ). The fund trades S&P 500 futures and options contracts of such futures in order to both generate income as well as offer some downside protection. The fund's approach is similar to NUSI ( NUSI ) with some differences, which I will discuss in this article.

The fund has been around for a little less than 2 years, and it has outperformed S&P 500 ( SPY ) slightly and NUSI significantly since then. It's difficult to tell if this outperformance will continue, but things are looking good so far.

So what does this fund do, and why am I comparing it to NUSI? This fund basically holds shares of an S&P 500 ETF ( IVV ), sells out of money-covered calls against it at multiple price points and multiple expiration dates in a layered approach and buys put spreads for protection. This is similar to NUSI's approach where the fund sells covered calls and buys protective puts which forms a position called "collar". I've already explained why I am not a huge fan of NUSI's approach in a past article. Long story short, buying naked put options costs so much money that it costs more to buy them on a monthly basis than the protection they offer. Basically I argued that NUSI is overpaying for insurance premiums to protect its portfolio against a rare event.

HEQT uses a slightly different approach where it buys layers of put spreads instead of buying puts which is cheaper. Buying put spreads doesn't offer the same level of protection as buying a naked put in the event of an extremely rare black swan event, but it should offer sufficient protection in most common cases where the market might dip 5-10% or slightly more in a month.

To make this clearer, let me show you what the fund is holding right now. Keep in mind that this is an actively managed fund and its holdings can change from day to day but the general idea and strategy should stay the same. First, the fund holds a large number of IVV shares which is basically an S&P 500 ETF (basically the same thing as SPY). Then we see that the fund sold three layers of covered calls, specifically $4360 calls expiring in August (already in the money), $4650 calls expiring in September (out of money) and $4750 calls expiring in October (out of money). Then we see three put spreads. Specifically the fund holds $3965-3340 spread expiring in August, $4210-3550 spread expiring in September and $4310-3625 spread expiring in October. Neither of these spreads are in the money.

Basically if the market were to crash next week down below $4310, the October spreads would kick in, followed by September spreads below $4210 and August spreads below $3965. October's spread would offer protection until we drop to $3625 but not below that, September spread would offer protection down until $3550 and August spread would offer protection down until 3340. Considering that last year's bear market bottomed around 3500, all these spreads would offer sufficient protection.

Speaking of which, let's see how this fund performed during last year's brutal bear market. From January 2022 until October 2022, S&P 500 dropped -24% while this fund dropped -11% (including dividends). The fund fell less than the overall market, but it still fell nevertheless. The funny thing is that NUSI fell even more than S&P 500 did during this period even though it held protective naked puts. It turns out that the protective puts offered more headwind than protection last year because they became more expensive as VIX climbed higher. Not only did NUSI's protection puts almost never kicked in, but also they became increasingly expensive to roll month after month. This was less of an issue with HEQT because it used spreads and a 3-month layered approach I mentioned above.

Since the fund is actively managed, it could offer a higher level of protection if the market were to drop significantly by simply rolling its call spreads lower. For example if S&P 500 were to suddenly drop to 4200, the fund could take its $4310-3625 spread and lower it to something like $4100-3400 spread which would expand the level of protection from $3625 to $3400. Since it's extremely rare for the markets to drop that fast even during bear markets (unless we are facing an event like the complete shutdown of the global economy in March 2020), these types of roll downs will not be necessary very often, and they will likely be used only in extreme cases.

One thing some investors might not like about this fund is that its dividend yield is much lower than similar covered call ETFs. This fund's current yield is under 4% which is significantly below other covered call ETFs some of which have double-digit yields. Many investors put their money into covered call funds for income purposes because these funds will often trade upside for income, so some investors might not find value in a fund that offers limited upside and limited income at the same time. Since Simplify has many high-yielding funds such as SVOL and HIGH ( HIGH ) for income investors, I am inclined to believe that this fund will also raise its dividends at some point in the future, but I don't have any evidence to support that. We will have to wait and see since this is a relatively new fund. So far the fund has made small distributions each quarter followed by one big payment at the end of the year which mostly capital gains.

Since the fund sells call options out of the money, it should allow for participation in at least some upside unlike funds like QYLD ( QYLD ) and XYLD ( XYLD ) which sell calls right at the money and no upside is possible beyond options received. The ideal market conditions for HEQT would be a market that's slowly climbing up, about 2-3% per month but not much faster than that. This would allow the fund to participate in most of the upside and turning a nice profit.

This is a fairly new fund and results look promising so far. It will likely continue to outperform similar funds like NUSI in total returns, but some investors might be turned off by low dividend yield coupled with limited upside. This fund is mostly for investors whose biggest priority is to avoid volatility and sleep well at night.

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