XYLD - SPYI Is An Interesting Income Play

2023-06-07 01:37:14 ET

Summary

• Neos S&P 500(R) High Income ETF sets itself apart from other covered call funds by selling call spreads, allowing it to participate in upside moves during bull markets.
• SPYI has outperformed major competitors JEPI and XYLD since October 2022, albeit slightly, due to the range-bound recovery of the S&P 500 index.
• The actively managed fund currently has a 12% dividend yield and pays monthly, making it a potentially attractive addition to a diversified income portfolio.

As the number of options-based income funds keep rising, Neos S&P(R) 500 High Income ETF ( SPYI ) looks like an interesting play that quickly gained some attention. The fund's AUM quickly rose from less than $1 million to $31 million as its somewhat unique approach seems to gather people's attention. Still, this is a very small fund and still in its very early days.

What sets this fund apart from other covered call funds is that the fund's active management doesn't limit themselves to simply selling calls. At times, they also sell call spreads which means that the fund doesn't totally limit its upside potential and it still gets to participate in some upside if there is a strong enough rally.

Let me show you how this works. When you sell covered calls, you give up all upside beyond your strike price for the price of the call premium. So if you buy SPY ( SPY ) at the current price of $428 and sell covered calls at $430, you can only participate in upside of $2. Your maximum profit is capped at $2 plus any premiums you collected (about $4-5 for monthly calls) no matter how high SPY goes. If the index has a blowout month, you miss out on the profits. This is why most covered call funds underperform during bull markets, especially at stages when rally accelerates.

Selling call spreads yields a different picture. In the same scenario let's say you bought $428 but now instead of selling call option at a strike price of $430, you are selling a call spread of $430-435. In other words you are selling a call option for $430 and buying a call option at $435 for the same price. Now you are collecting a smaller premium than you would if you only sold call option instead of a call spread but your upside is not capped. If SPY ends your option period between $430 and $435 you collect the premium from call spreads and it marks your maximum profits (plus the $2 between current price of $428 and $430) but if SPY climbs above $435, you participate in all of the excess upside beyond that in addition to the premium you collected. Your profit chart now looks like below.

Of course you can set up your spread in many different ways. You could do $430-435 or $430-440 or $432-437 or any different combinations. It's up to you to decide where to set your spread. This is basically what SPYI does. It sells call spreads so that it can collect those juicy monthly premiums but still participate in upside moves if the market suddenly has one of those monster moves which it often does during bull markets. This also allows the fund to participate in V-shape rallies that most covered call funds miss out on.

Let us look at how this fund performed compared to similar covered call funds since SPY bottomed last October. Since these are all high-yield funds, we will focus on total returns. In the below chart you will notice that SPYI outperformed two of its major competitors JPMorgan Equity Premium Income ETF ( JEPI ) and Global X S&P 500 Covered Call ETF ( XYLD ) but not by that much. This is because SPY's recovery in the last 8 months has been somewhat range-bound. Since January SPY has been in a tight range between $400 and $425, which it is barely starting to break out. When the market trades at a tight range, traditional covered call funds do the best, yet SPYI still outperformed its peers even though it was a slight outperformance.

We would have probably be looking at different results and vast outperformance for this fund if it was based on Nasdaq ( QQQ ) instead of SPY because QQQ is up from $260 to almost $350 since Christmas, representing a climb of $90 in less than 6 months. But SPYI is not based on Nasdaq and SPY's recovery has been more range-bound, limiting this fund's performance but it still did very well.

When we are dealing with covered call funds (or selling covered calls ourselves) based on S&P 500 index, one thing we need to pay close attention to is VIX. In most basic terms, VIX is the expected volatility of S&P 500 index options one month out. When VIX is higher, option premiums are richer and when VIX is lower, they tend to be poorer because of the market's expectations of lower volatility. Currently VIX is at the lowest level it's been since the COVID-19 pandemic that started in February 2020 which means option prices are very low. This is why we are starting to see sharp dividend reductions in funds like XYLD. Meanwhile this could have a different effect on funds that sell spreads because not only the options they sell but also the options they buy get cheaper so these funds are less affected by sudden shifts in volatility.

Since SPYI is an actively managed fund, it doesn't always follow the same trends. Sometimes it sells tight call spreads (meaning less gap between sold option and bought option), other times it sells wider spreads and at times it doesn't even do spreads at all. When I look at the fund's current holdings as of 6/6 (subject to change), I am seeing that it sold a relatively small number of SPX call options at 4265 and at 4315 both expiring on July 23th. The first option is already in the money and the second one is within ~1% of being in the money. I am not seeing the fund holding any call options though so it's not building a spread right now. This tells me that the fund's management don't believe that stocks will rise much in the next month and half and they are placing their bets accordingly. Since this is an actively managed fund, its positions are subject to change without a notice on almost daily basis.

The fund currently has a dividend yield of 12% and it pays monthly. In other words it has a monthly dividend yield of 1%. In the future this could drop or rise based on market conditions and volatility expectations but so far it's been very consistent for the fund. Granted the fund hasn't been around for that long but it's been paying consistent dividend payments of 49 cents every month.

What's the final verdict? It's probably too early to tell whether this is the best covered call fund or whether it is better or worse than some of its competitors such as JEPI and XYLD but its early results are encouraging. It definitely has a place in my portfolio and it could be in yours too if you are into collecting high-yields from option-based funds. I believe this is a nice addition to a highly diversified income portfolio especially if you plan on reinvesting dividends.

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