SVOL - SVOL Can Be A Good Addition To Your Income Portfolio

2023-05-30 05:44:03 ET

Summary

• Simplify Volatility Premium ETF (SVOL) is a fund that short sells VIX to collect premiums and offers a 17% dividend yield, making it a potential addition to income-oriented portfolios.
• The fund's strategy involves selling VIX futures contracts and buying VIX call options as a hedge, generating income from time premiums even when VIX remains flat or low.
• Although the fund has performed well during its short existence, it should be considered a complementary addition to a well-diversified portfolio due to its derivative nature.

Simplify Volatility Premium ETF ( SVOL ) is an interesting fund that short sells VIX to collect premiums and pays a rich dividend yield of 17%. The fund has been around for only 2 years and so far it has performed nicely during this highly volatile period, not to mention last year's brutal bear market. I could see this as a good addition to portfolios of income oriented investors, especially if they are into covered call funds.

First, let me clarify one thing. This isn't a covered call fund. As I will explain below, the fund's strategy is completely different from that of a covered call fund. The reason I am saying this fund would be a nice addition to portfolios of investors who love covered calls is because it can act as a hedge on your income. Since covered call funds sell options for a premium and pass those premium money to investors in shape of dividends, their dividend payouts are highly dependent on volatility measured by VIX. When volatility (and VIX) are up, call premiums are richer but when VIX drops, calls premiums also drop, triggering a decline in dividends. This fund can fill that gap by shorting VIX and its rich dividend yield can supplement income side of your portfolio when volatility is falling.

So, what exactly does this fund do? In order to better understand this fund's strategy, let's take a look at its current holdings .

Most of the fund's assets are in cash and bonds but this is expected since the fund uses cash as a collateral against its main plays. The most important parts of this list would be lines 3 through 6. Those 4 lines actually explain what exactly the fund does in order to generate those rich premiums. Currently we are seeing that the fund is selling VIX futures contracts for July and August 2023 in two batches. Notice that July VIX futures contracts sell for $21.05 and $21.75 respectively even though VIX currently sits at $17.95. The difference is due to time premium. Selling futures contracts is very similar to selling options contracts even though buying them can be vastly different because buying options gives you the option to buy/sell an asset which you can choose to or choose not to exercise, whereas buying futures contracts actually gives you obligation to buy/sell and asset so from a buyer's perspective there are some differences.

We see that the fund collects about $3-4 in monthly premiums selling VIX futures contracts. It also buys VIX call options with a strike price of $60 a few months out. These options serve as a hedge in case VIX suddenly blows up like it did during March 2020 crash.

It's unclear why the fund chose to sell VIX futures contracts instead of VIX call options and the fund doesn't explain this in any of its documents but I suspect it might have to do with taxes. Investors buying this fund should be comfortable with the fact that they are utilizing futures contracts instead of selling options for income generation.

Now let us talk about VIX which is bread and butter of this fund. Also known as the Volatility Index or Fear Index, VIX can technically range from 0 to upwards of 100+ but the index has spent the vast majority of its existence in a tight range between 15 and 25. It's rare for VIX to drop below 15 or rise above 25 for long periods of time and the index tends to return back to its "normal range" sooner or later. This is because VIX is basically calculated from premiums people pay for call and put options of S&P 500 one month out. When there is a lot of fear in the market, people buy a lot of put options either as an insurance for their portfolio or as a tool for generating profits, thus option premiums rise. When the fear recedes, people don't want to pay a premium price for options anymore so VIX drops.

During the COVID crash of March 2020, VIX rose to as high as 75+ but that was an extremely rare event. Driven by an almost complete shutdown of global economy, markets saw many days of limit-down sell offs triggering multiple circuit breakers and VIX quickly jumped to very high levels. Similarly, we saw VIX drop at the same velocity that it rose once the initial fear wore off as you can see in the chart above.

Apart from crashes like those, it's very rare for VIX to climb above 30 and even rarer for it to stay there for prolonged amount of time. Last year, we were clearly in a bear market where S&P 500 dropped about 22% from top to the bottom yet even in a bear market like that, VIX rose above 30 only in a few instances and every time it rose above 30 briefly it dropped back in 20s in a very quick manner. Even during October lows when S&P 500 briefly touched to levels below 3500, VIX didn't climb much above 32.

What does it tell us? It tells us that it takes a lot of force to take VIX up to very dangerous levels. Think of it like this, during a bear market when the market first starts dropping, a lot of people buy put options in order to either insure their portfolio or benefit from a downside move but once the market has already fallen significantly, there is very little incentive for people to overpay for puts. For example last year people might be inclined to buy a lot of puts as S&P 500 was dropping from 4800 to 3500 but once it was near the bottom, it made little sense for people to pay a high option premium for puts because downside was more limited and markets would have to drop considerably more in order for those puts options to be profitable. This is why VIX starts dropping quickly once the market is close to the bottom as put buying activity starts drying up.

For investors of SVOL this is encouraging because it means that even if VIX starts climbing and this fund starts dropping in value, you know that it won't last long. VIX can climb quite high during an initial market slide but it rarely stays high. In comparison, VIX can stay low for a very long time. For example when we look at the 3-year period between January 2017 and January 2020 (right before the COVID crash), we see VIX mostly hanging out in a 10-15 range for the vast majority of the time except for a couple brief spikes in 2018. Again, those spikes didn't last long as you can see in the chart below.

You might think that SVOL won't make any money during periods where VIX is low because it doesn't have much room to drop. After all this fund is technically "shorting" VIX and something has to drop in price for short sellers to make a profit, right? Well since the fund is actually shorting VIX future contracts with time value, VIX doesn't have to drop for the fund to make money. VIX can stay flat and this fund can still make money from collecting time premiums. For example currently July's VIX futures sell for about $21 per contract even though VIX is currently sitting at below 18 which means the fund will make money as long as VIX isn't above 21 by July.

The fund also owns some VIX call options (strike price 60) as a hedge in case VIX really blows up but it's extremely rare for VIX to climb to those levels so I don't really think those call options will be triggered anytime soon. In fact, the fund should probably sell them at a lower strike price for better protection even though it will cost a bit more and perhaps eat into some of its profits but it might be a good price to pay. Then again, since VIX doesn't stay high for long and comes back to "normal" after every large spike, the fund should be fine as long as it's not leveraged (which it isn't right now).

Since the fund hasn't been around for long, it's hard to talk about its long-term performance. The fund's dividend history tells us that it's been making steady monthly payments since its inception. The fund never had to skip a dividend payment or even reduce its payments in a significant way. So far the fund is doing what it promised it would be doing and it's also been beating overall market returns since its inception.

Still this is a derivative fund and investors should put only a small percentage of their total portfolio value into this fund. With its 17% dividend yield, this should be seen as nice complimentary addition to a well-diversified portfolio but not as cornerstone of a portfolio.

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