QYLD - SVOL: It's Time To Trim (Rating Downgrade)

2023-12-25 07:12:29 ET

Summary

• SVOL is a well-designed income ETF that hedges out black-swan convexity risk.
• The ETF sells VIX futures to generate yield, producing a similar income but a superior risk profile to other income ETFs.
• While we expect the yield to remain solid, the AUM of the strategy may decline in coming weeks and months, potentially impacting absolute returns.
• The market's rally appears fragile, and could soon falter. Getting ahead of a spike in IV and a rotation into bonds seems prudent.
• SVOL is still a good long-term income option. Wait for normalizing conditions when looking to time a re-entry from here.

Back in September, we wrote an article titled " SVOL: The Best Income ETF On The Market Sells VIX Futures ".

The core thesis of the article was that SVOL , the Simplify Volatility ETF, was a well-designed financial product built to take advantage of typical market conditions, while also hedging out a good bit of black-swan convexity risk.

In other words, it was a better income option than many of the income ETFs on the market today, some of which we have derided in the past.

Our thesis about SVOL remains true. The underlying strategy the ETF uses should continue to produce returns and solid yield into the future, and potentially into the long term. However, we're concerned about how the ETF might perform over the short and medium term, given how the market currently looks.

Thus, it may be time to trim your stake in SVOL in favor of more defensive options for the time being.

Let's jump in.

How SVOL Works

In case you're new to SVOL, or didn't read our initial article, the ETF produces yield in a different way to most of the income ETFs on the market.

Most income ETFs, like QYLD , will own a position in a common underlying index, like the Nasdaq 100. Then, they sell calls on that position in order to generate yield that is distributed to shareholders.

By contrast, SVOL simply sells VIX futures on a continuous basis. This produces a similar yield profile to the other ETFs, as it is also short volatility.

However, unlike selling covered calls (which causes long term asset decay given how these funds do it), SVOL's underlying base simply fluctuates with the volatility markets.

Functionally, here's how this strategy produces yield :

VIX futures are almost always priced higher than the VIX itself. Visually, you can see this below, where the red line is the VIX, and the white line is the front month VIX future:

The reasons for this premium are many, but it basically has to do with the fact that VIX futures are a traded instrument, and those with exposure to it are always at risk of the VIX exploding in value, and so the fair value of VIX futures has to bake in this possibility, thus distorting price higher.

The VIX, however, is just the VIX, which means that most times it will trade lower than the futures, but occasionally it will spike up above them. This is the risk inherent in the asset class, simply due to the nature of fear and panic itself - it comes in clusters.

Practically speaking, though, it means that the ETF is selling futures at the white line and buying them back (letting them cash settle) at the red line. When done over and over, this produces profit when the VIX is flat or going down.

There is no reason that these underlying market dynamics will stop anytime soon, as they are linked directly to human behavior.

Why SVOL Is Primed To Underperform

That said, we see that the period moving forward may be a period in which the ETF is set to produce substandard absolute returns.

So far in 2023, SVOL's total returns total more than 21%:

However, a good portion of this return has been from the consistent distributions.

Without the yield, the AUM of the ETF has traded mostly sideways:

This is where our concern lies. The yield will likely continue to be solid, but the AUM of the strategy may be due for a dip, overtaking the yield and producing negative absolute returns.

There are two reasons that we think this could happen.

First , the S&P 500 is categorically overbought:

On short-, medium-, and long-term regressions, the index is trading at the very top of its historical range. This doesn't mean anything per-se, as the market recently broke out to all-time highs.

Thus, some strength is expected.

However, the Relative Strength Index, or RSI, is trading at 71, which is commonly thought of as an "Overbought" reading.

Additionally, the index is trading at nearly 3% above its average pricing zone, which is on the high end historically.

Finally, the Average Directional Index, which measures market trendiness, is at 51.6, its highest level since 2018:

This indicates that the market's recent trend is historically abnormal and could be set to slow or stop.

Taken together, the S&P 500 appears set to correct.

But how does this affect SVOL?

Hypothetically, it doesn't. If the S&P 500 simply trades sideways and chops around for a time, then SVOL shouldn't experience any serious issues, as implied volatility remains low.

However, in reality, in the event of a correction, implied volatility will rise. This is due to a number of self-reinforcing cycles in the market. The key thing is that ranges expand in the event of a selloff, which causes market makers to bid up IV.

This means that the VIX will increase, which should hurt SVOL's NAV, as the fund holds a large short position in VIX futures.

All in, Implied Volatility appears set to increase, and SVOL's NAV appears that it could be under pressure.

Second , realized volatility has been low.

For those unfamiliar, realized volatility is simply the amplitude of the real traded ranges in the market.

Looking historically, the S&P 500 is at the very low end of short term realized volatility so far in 2023:

Given that volatility has a tendency to mean revert, it's highly likely that the market could see higher RV in the future.

RV dislocations aren't always an indication of potential changes in IV, which would affect SVOL's asset base of short VIX futures.

However, when combined with point number one, a picture begins to emerge that strongly suggests that the VIX is set to climb, which would negatively impact an SVOL position.

Thus, while the long-term thesis for SVOL remains intact, it may be prudent to reduce risk for the time being until the technical conditions we've discussed come back into line.

As IV remains low, it may be worth taking the opportunity to "Sell High" in SVOL.

What To Buy

That leaves one question: What should you buy with any freshly freed-up cash?

In our opinion, TLT , the iShares 20+ Year Treasury Bond ETF, seems like a good option.

The yield is meager compared to SVOL, at only 3.34%.

However, as it appears that the rate hiking cycle may be over , TLT seems to be a solid place to store capital.

If rates are cut, then TLT could be in store for some mild capital appreciation.

If rates stay where they are, then the yield looks good and there doesn't appear to be much in the way of material downside risk.

The key thing to watch here would be inflation. If that picks back up, then all bets are off.

Another benefit of rotating into TLT is that when stocks sell off, typically money rotates into bonds, which could offer further protection from a spike in volatility and a broader market selloff.

In this way, rotating could prove advantageous; getting ahead of other market participants that may move more slowly in the event that the market does see an increase in uncertainty.

Thus; our strategy - trim SVOL, and buy TLT for the time being .

Summary

All in all, the S&P 500 appears likely to sell off in the coming weeks and months, which could negatively impact SVOL.

Trimming a position and buying TLT could be a great way to wait out the storm before entering back in at a better price.

Eventually, things will come back into line, and SVOL will look attractive again. Look for normalizing trend & technical conditions as a way of timing a re-entry into SVOL's high income upside.

Cheers!

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