RYLD - RYLD: VIX Index Suggests It Is The Worst Time To Sell Options In Years

2023-06-20 17:40:41 ET

Summary

• Financial markets have been more stable in 2023, with mega-cap stocks seeing significant gains but small-cap stocks remaining nearly flat.
• Option-selling ETFs like RYLD may underperform due to low option premiums and are unsuitable for income investors seeking steady returns.
• The Russell 2000 index may outperform the Nasdaq 100 and S&P 500 over the next twelve months as market breadth normalizes.
• I believe RYLD is best avoided due to depressed option premiums on the Russell 2000 and the likely permanent principal decay of the ETF.

Throughout most of 2023, financial markets have been far more stable than they were over the years prior. Overall performance of various stock market indices varies significantly, with mega-cap stocks rising tremendously YTD, while most small-caps are nearly flat. The market's "breadth" in 2023 has generally been poor, with only the largest stocks seeing the most significant gains. Further, following the recent rally, the popular " Fear & Greed " Index has reached its "Greediest" level since 2021. Key components of that measure, such as the VIX index and the put-to-call ratio, signal immense "greed" due to generally low implied volatility levels and a significant interest in call options over put options. See below:

The VIX index is currently around its lowest level since before the 2020 "COVID crash," while the put-to-call ratio is roughly the lowest since the 2022 drawdown began. These two measures strongly indicate a lack of risk perception in the market, signaling a relatively bullish market consensus. In general, option sellers outnumber buyers (low VIX), while call buyers outnumber put buyers (signaling a lack of downside protection interest). These signals can mean one of two possibilities, either the stock market has entered a new phase of resiliency, or many investors are underestimating risk levels.

These metrics have direct impacts on the profitability of option-selling. Option-selling ETFs have become very popular in recent years due to their high yields, often as great as 20%, as in the Russell 2000 ETF ( RYLD ). However, RYLD's actual dividend over the next twelve months will almost certainly be much lower than its staggering 20% TTM figure because option premiums are very low today - as implied by the VIX ratio. Indeed, the Russell 2000 ETF ( IWM ) currently has an implied volatility of 18%, its lowest measure over the past year, when it averaged around 25% or greater. This data directly implies that selling options on IWM will deliver the lowest yield compared to the past year.

I have been bearish on RYLD since 2021, as described in " RYLD: Dividend Yields Can Be Deceptive With Option Strategies. " RYLD's principal has declined by 30% since then, while its total return was -12.3%. Accounting for dividends, the fund has performed around as well as the Russell 2000 index since mid-2021. However, due to the sharp decline in option premiums today, I suspect it is more likely to underperform that benchmark over the coming year, creating significant potential risks for investors. Further, many investors may not fully understand RYLD's strategy, exposing them to a likely complete decay of initial principal investment into the ETF if held indefinitely.

RYLD is Likely to Underperform IWM

Option-selling ETFs like RYLD sell call options each month near the current index price. Any performance in the Russell 2000 over a few percentage points in a given month is "capped" as those returns go to option buyers. In other words, during bull markets, RYLD will generally underperform the Russell 2000 or its related ETFs like IWM). Further, RYLD has no "downside cap," so it declines 1-for-1 with the Russell 2000; however, the option premium it receives does offset those declines. Thus, RYLD can outperform during bear markets, particularly if "market fear" remains high, so slow-moving bear markets, such as 2022, generally see some outperformance for RYLD. Indeed, RYLD outperformed IWM by around 3% during the slower 2022 drawdown. See below:

RYLD has performed around the same as IWM since mid-2022, with a slight trend toward underperformance. RYLD performed well as option premiums rose earlier last year due to increasing volatility in the bond market. However, since the Russell bottomed around mid-2022, waning option premiums have lowered its potential.

Suppose the Russell 2000 catches up to its larger peers. In that case, RYLD may have positive performance but should not perform as well as direct Russell 2000 index funds because its monthly return potential is capped, and its premium income is lower today due to the low VIX index. Further, if the stock market rapidly crashes (due to growing recession risks), RYLD will outperform the Russell 2000, but likely only by a few percentage points. For example, during the six-week 2020 crash, RYLD fell ~31.8%% from peak to trough while the Russell 2000 declined by ~33.3%. RYLD also underperformed over the recovery period later than the year since its upside was capped and the Russell 2000's was not (data assumes dividend reinvestment).

RYLD will only outperform when implied volatility is significantly above actual fluctuations. Or when risk perception is much greater than risk reality and markets are not rising or falling too quickly. Over recent years, partly due to the increased popularity of option selling, that situation seldom persisted for over a few months, as there are typically more people interested in selling options than buying. Slower-moving bear markets, such as that of early 2022, are the exception; however, owning RYLD in that environment is still no benefit because its absolute performance will still be negative.

RYLD is Not Suitable For "Income Investors"

Today's ultra-low premiums on IWM imply RYLD's dividend will decline to its lowest levels since before 2020 unless volatility spikes again soon. The reality is that RYLD's "dividend" is nothing like dividends found in bonds and stocks, which have stable dividends that rarely change, even with large fluctuations in asset prices. RYLD is unsuitable for investors looking for a steady income because its dividend will fluctuate dramatically with changes to option premium (or implied volatility) levels.

On the one hand, RYLD's dividend usually rises during bear markets with implied volatility levels. However, because RYLD's upside is capped while its downside is not, it will inevitably decay all of its principal value. Since most of these ETFs are new, few investors seem to appreciate or understand this risk factor. That said, over a 5-10 year timeframe, RYLD (and peers) should lose almost all of their initial value unless there is a strong and consistent bull market. If dividends are consistently reinvested, then loss of capital can be avoided.

However, generally speaking, option-selling ETFs are much like "reverse mortgages" in terms of income potential - they are truly returning equity to investors monthly, with equity inevitably declining unless the underlying asset value continues to appreciate (such as hoping a home appreciates quickly enough to offset a reverse mortgage). In reality, asset values rarely keep up with capital outflows indefinitely. So, given the interest of retired investors in RYLD (and peers), it must be noted that this ETF is not a suitable income source. It can be used as an income source if an investor is OK with inevitably losing their initial investment. Further, because RYLD's capital will inevitably decline, its dividend return will as well since its option premium returns depend on invested capital.

For these reasons, the SEC (and the IRS) do not recognize option-selling premiums as income. The current, far more accurate, "SEC yield" for RYLD is 1.00% today , meaning its actual dividend (that does not come from premiums that cost capital) is 1% after accounting for the fund's expense ratio. In general, that means that investors in RYLD should not take more than 1% of their initial investment per year, or else face some decay compared to the Russell 2000's overall performance.

Russell-Nasdaq Ratio is a Silver Lining

Overall, I believe that RYLD offers no actual benefit to other non-derivative Russell 2000 ETFs. While RYLD's TTM yield appears attractive, virtually all that "income" is a slow return on invested capital. In certain circumstances, when implied volatility levels are very high, RYLD may be a sensible strategic option over the Russell 2000. However, in today's circumstances, when implied volatility levels are depressed, it is more likely that RYLD will underperform due to low premium returns. Further, I believe the market's "extreme greed" positioning, mixed with the "recessionary" yield curve inversion, signals a mismatch between sentiment and fundamentals - likely suggesting realized volatility may soon be well-above current implied volatility levels.

One positive point for RYLD is the value in the Russell 2000 compared to the Nasdaq 100. The Russell 2000 currently has a very low TTM "P/E" of 11.4X , while the Nasdaq 100's roughly 37X . This huge valuation discrepancy accounts for the difference in EPS growth outlooks in the underlying stocks; however, I do not believe such a large gap is sensible and is likely derived from excessive bullish speculation on mega-caps, combined with "FOMO flight" from small-caps. The performance ratio between the two related ETFs has reached an extreme low today. See below:

In my view, this situation dramatically benefits the Russell 2000 over the Nasdaq 100 and, to a lesser extent, the S&P 500. Market sentiment is highly skewed toward a small number of massive companies, likely causing them to become overvalued, while the smaller stocks in the Russell 2000 appear comparatively undervalued. In my view, due to the slowing economy and remaining inflation strains, it is unlikely that the Russell 2000's 12-month returns will be notable (or even necessarily positive); however, I strongly suspect that the Russell 2000 will outperform the Nasdaq 100 (and the S&P 500) over the coming twelve months as market breadth continues to normalize.

The best way to take advantage of that potential opportunity would be an IWM/QQQ pair trade (buy IWM and short QQQ), limiting any exposure to the stock market's overall performance. However, I suspect both IWM and RYLD are vastly superior to QQQ or ( QYLD ) due to the seemingly significant overvaluation of mega-cap stocks. To me, that is not a sufficient reason to be bullish on either RYLD or IWM today, but enough to suggest that RYLD may outperform other option-selling peers like the Nasdaq 100 option-selling ETF QYLD. That said, I remain bearish on RYLD and suspect it will lose more value over the coming twelve months than it has since I covered it last.

For further details see: