RYLD - RYLD: A Clearer View

2023-08-14 06:24:52 ET

Summary

• RYLD's covered call strategy offers statistical benefits and an appealing distribution schedule but faces challenges in the current economy.
• The nature of its underlying index manifests a challenging climate for RYLD in spite of its healthy option premiums, 2.7% monthly over the past year.
• Despite those healthy option premiums, RYLD's total return warrants a Sell rating, regardless of distribution level.

The Global X Russell 2000 Covered Call ETF ( RYLD ) applies a covered call option strategy to its portfolio, which itself emulates the holdings of the Russell 2000 Index. In this regard, its stated target index is the Cboe Russell 2000 BuyWrite Index (BXR). A covered call strategy does offer the statistical advantages of transforming normally distributed returns so as to reduce volatility and increase the likelihood of positive monthly returns while maintaining the overall average return. RYLD's target index, monthly return profile, and statistical differences from the Russell 2000 were detailed in my January 2022 article and will not be repeated here.

Despite RYLD's generally beneficial statistical characteristics, the Russell 2000's large swings over the past year have resulted in RYLD repeatedly going through a painful cycle: almost all of the loss, almost none of the gain. While a covered call strategy may be considered suboptimal in relation to an investor's utility, most of the blame here can be laid to the index. Even as RYLD collected healthy option premiums over the past year (2.7% monthly), the performance of its total return (with distributions reinvested) makes for a situation leading to a singular result: A Sell rating.

Call Options

Each month, the portfolio managers collect option premiums from selling near at-the-money (just slightly out-of-the money) call options, distributing approximately 1.0% and reinvesting the remainder into the fund. Over the past 12 months, the reinvestment averaged 1.7% monthly.

These levels are consistent with numbers from previous years, the monthly averages for which are shown below. The values are inferred from the price action of RYLD relative to its underlying index. While some investors view covered call strategies through the general lens of VIX levels, this chart provides a more direct view. Options prices this year have been below their historical average, the driving force behind past performance.

The 1% distribution level was chosen arbitrarily by Global X portfolio managers as appealing to investors, apparently targeted to those seeking income. One may wonder whether or not the healthy distribution had an adverse effect on long-term performance, but as we will see, RYLD deserves its Sell rating regardless of the distribution level.

Attribution

RYLD has a history of a little more than 4 years. Its performance, along with that of its target index and underlying index, are attributed below.

Investors taking monthly distributions would see their initial net asset value ((NAV)) down 27% ((RYLD)) whereas those reinvesting them would see an increase of 18% (RYLD-Adj). The fund's performance has tracked its target index (BXR) well since its inception, so no one should find fault with its portfolio managers. Those seeking direct exposure to the Russell 2000 index would have a 35% increase in NAV with dividend reinvestment in VTWO , the Vanguard Russell 2000 ETF.

It is worth remembering: even if option premiums collected over each of the past 12 months were 0.5% higher, averaging 3.2%, this would not be enough to change the overall impression of RYLD.

A direct comparison of this active strategy with its input is relevant. Although the total return of VTWO is up almost double that of RYLD, this is not enough to warrant a general conclusion of outperformance.

The trajectory of the historical difference in their NAVs shows little consistency, with long stretches favoring one or the other. Despite average return favoring VTWO, its monthly return beats out RYLD fewer than 50% of months. Taking into account the relative magnitude of the terminal difference (17%) to the range (from negative to more than 30%) no one should conclude that VTWO would be deserving of a buy rating in the presence of RYLD's sell rating. With inflationary pressures and rising interest rates, the economic climate going forward does not favor the relatively smaller constituents of the Russell 2000 index, either.

Conclusion

When considering an investment with an active strategy, both the active strategy as well as its input must be examined. While the covered call overlay is by no means perfect, the Russell 2000's repeated seesaw price action manifests mostly the strategy's disadvantages. Even moderately higher option prices would not fix this situation. RYLD's rating is Sell.

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