QYLD - RYLD: A Magnet For Yield Chasers Not Worth Your Time

2023-12-11 05:59:57 ET

Summary

• Global X Russell 2000 Covered Call ETF sells monthly call options against RUT, an index of US small-cap stocks.
• RYLD's options strategy limits its upside exposure to the index, resulting in missed opportunities for investors.
• The return of capital dividends introduces tax implications that are advantageous for some investors, but individual tax situations may vary.
• Global X's YLD strategies are inherently flawed in how they handle volatility. Low VIX does not bode well for next week's roll.

Introduction

The Russell 2000 (^RUT) is an index of small-cap US stocks and is considered to be one of the important indices to watch in the American stock market because its component companies are riskier to hold and are more sensitive to changing economic conditions. This has given rise to incredibly large ETFs and funds that track this index, like the 56B AUM iShares Russell 2000 ETF ( IWM ).

Global X Russell 2000 Covered Call ETF ( RYLD ), which debuted in April 2019, uses the index as an underlying holding in its options strategy.

RYLD's strategy is to "buy-write" the Russell 2000 index, or buy the index and write (sell) call options to generate premium. You cap your upside but are able to generate monthly income for investors. How has it done?

It has performed admirably over its lifespan so far, mostly staying in line with the index while mostly maintaining monthly distributions at an incredible yield.

So why is my title and rating so negative? Well, there's an elephant in the room that we have to talk about: options.

The Use of Covered Calls

This is not the first covered call fund I've written an article on, and certainly not the last one I will give a "sell" rating for the exact reason RYLD is getting one: systematic, unresponsive options strategies.

Unlike actively managed funds like the JPMorgan Nasdaq Equity Premium Income ETF ( JEPQ ), which I gave a "hold" rating to last month , which dynamically adjusts their exposure to the short and long side of the options premium trade, RYLD sells options against the entirety of its assets at all times.

This means that RYLD's upside exposure to the Russell 2000 is very limited, despite its downside exposure being essentially 100% since the call options are rolled at-the-money or "ATM" monthly on a set schedule, one day before expiration. This means that there is no manager discretion in strike selection or timing.

Active management is a quality I look for in options funds in particular because the options market is far more illiquid and brimming with mispricing opportunities than the equities market.

This passive method of rolling options means that the fund will sell an option every month no matter what the market's condition is.

We can see how missing out on the upside, capped due to our ATM short positions, has eroded the price of RYLD since its launch.

The fund is profitable when implied volatility, which drives a significant amount of options pricing for ATM options, is lower than realized volatility. So long as options sellers make more premium than they lose having to roll losing positions, they are profitable.

Note that in the above chart, the orange line is IWM's implied volatility moving average. Investors will profit from the trade most when that line is above the lavender line, which is the historic volatility moving average.

Historic volatility was above implied volatility 36.5% of the time (92/252 trading days in the last year), meaning that investors largely were able to generate yield from the ATM calls RYLD sold on 63.5% of trading days.

As far as options strategies go, that's adequate.

Currently, RYLD is short the RUT 12/15 1800C. Assuming that it was long the index at the same price (remember, it sells ATM options), the trade looks like this:

The payoff grid needed a proper zoom-out since the option is so far in-the-money or "ITM."

Once they roll the position out next week, the breakeven line will adjust back to where the dotted white-line is now, RUT's price, as the fund rebalances its holdings and sells another set of monthly ATM calls.

As always, for those of you who "speak Greek," here is the position's current info.

Note the very high amount of Vega. The position is very sensitive to changes in volatility. Refer back to Figure 5 if you're unsure of how to feel about that.

You should feel a little worried.

Looking back at this month, we can track how this position performed.

Note that this has been a loss for the fund. This makes sense, as the Russell 2000 is now sitting 79 points (4.2%) ahead of RYLD's strike. This is upside that investors missed out on, and explains the difference in total return we see between RYLD and RUT in Figure 1.

Looking back at even longer trends, we can see that these periods of capped upside have been very damaging to RYLD's total return.

This is because, as shown in the chart above, when the Russell moves above its volatility, it does it sharply before retreating. This can cause periods of loss, like we saw in much of 2022.

Those losses are not as bad as equity, since it is padded by distributions to shareholders.

Shareholders of RYLD were pleased in 2022, ultimately, as their total return outperformed the index despite near identical capital losses. Many other covered call funds also performed well, as it was a year of relatively high amounts of volatility, especially when compared to how 2023 has been.

With the VIX still low, it is definitely not a good time to start a position. I would much rather be selling ATM calls when volatility is high. The lower volatility is when RYLD sells their next month's call next week, the worse off investors will be if volatility rises.

Looking at the chart above, there were very few times in the past few years worse than now to be selling ATM calls.

Counterpoint: Tax Implications

This is where, as a financial adviser who is tax-conscious in my practice, I have to give the fund a fairly positive review.

Because a premium is given to investors via dividend distributions, all losses on the sold call options are eaten by the fund's NAV. Subsequently, the price consistently falls over time, even if the total return stays positive due to dividends received.

This, paired with the fund's distributions primarily being comprised of "return of capital" income, sets up investors for potentially large tax savings against a fund that distributes ordinary income.

"Return of capital" is not considered ordinary income and instead, the income you receive is put toward lowering your cost basis of the shares themselves. As RYLD's price declines, distributions lower your cost basis.

Capital gains can be deferred as long as RYLD shares are hold, and no income tax will need to be paid by shareholders on distributions.

If you'd like to know a bit more about distribution taxes (I'm sure my comments section is going to be very contentious about this), TDAM does a great job explaining RoC .

This is advantageous for some investors, but beware that your individual tax situation may differ.

Conclusion

The Global X Russell 2000 Covered Call ETF earns a sell rating from me for its tone-deaf options management strategy, which has resulted in a fund that mostly distributes capital back to shareholders and produces very little "income."

This has given the fund and its sister funds ( QYLD , XYLD , etc.) an unusual tax situation that presents itself as potentially favorable for some investors depending on your tax situation.

Ultimately, RYLD is not recommended as an equity income vehicle and the only equity premium ETF I recommend and personally hold is Simplify Volatility Premium ETF ( SVOL ), which I have given a buy rating to here , and a hold rating to here .

It is currently on track to earn itself an upgrade, but I am withholding my judgement until I see December's distribution announcement.

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