SVOL - SVOL: Looking To Generate Income From The VIX? Look Elsewhere

2023-12-21 11:19:27 ET

Summary

• Volatility funds have become popular for gaining exposure to the S&P 500 volatility index, but there are risks involved.
• The Simplify Volatility Premium ETF offers a different approach to shorting the VIX with a hedging strategy and lower risk exposure.
• Recent distribution trends and the low VIX make SVOL less attractive for investment at the moment.

Volatility funds became extremely popular in recent years, as they help investors gain exposure to the S&P 500 volatility index, or VIX, either long or short. Short volatility funds have produced absolutely enormous gains over time as this 10-year old equity bull market rages on, and volatility generally remains low. There are risks to this strategy, of course, as we saw some volatility funds actually liquidate due to massive tail risk spikes in the VIX in years past. Still, over time, shorting the VIX is a proven winner.

Enter the Simplify Volatility Premium ETF (SVOL), which is a different take on shorting the VIX. There are plenty of funds that short the VIX (or get long the VIX) at 1X, 2X, or even 3X daily returns of the VIX. SVOL takes the other side and actually reduces leverage to the VIX. It also has a hedging strategy in place that other volatility funds don’t employ, so the model is certainly interesting. However, given the recent trend of distributions, and the fact that the VIX is already very low once again, I believe it's most prudent to pass on SVOL and invest elsewhere.

A differentiated model

As I mentioned, I haven’t personally come across another find quite like SVOL, and that’s a good thing. The fund is innovative, and the reason is it employs what is essentially a low volatility way to gain exposure to volatility. Other VIX funds thrive on massive risk/reward, whereas SVOL is attempting to gain measured, lower risk exposure to shorting the VIX.

The strategy focuses on keeping -0.2X to -0.3X exposure to the VIX (for an average of -0.25X) to maximize income while generating less volatility in the price of the fund. In addition, it has long VIX exposure with deep out-of-the-money VIX calls to hedge against massive spikes in the VIX. I mentioned some funds liquidated (i.e.: went to zero) during huge spikes in the VIX and that’s because those funds were not hedged; SVOL is hedged so that risk is all but eliminated.

The goal here is to provide high levels of income, low levels of price volatility, and protection against black swan events in the VIX. The fund also pays monthly distributions, which is much preferred to the traditional quarterly distributions.

At a high level, I like the idea of SVOL, and I like the strategy. Getting short the VIX at a 2X or 3X rate isn’t for everyone, because the VIX itself is extremely volatile, so price movements can be absolutely huge. And as I mentioned, most short VIX funds don’t offer hedging against possible liquidation events, whereas SVOL does.

So where does it fall apart for me? Recent distribution trends are troubling in my view, and the fact that the VIX is very low today means I see upside in SVOL (and other short VIX funds) as limited for the time being.

Net investment income needs to improve

SVOL has an impressive distribution history, as we can see below. It’s been distributing 30 cents per share every month since July, and was slightly higher before that. The problem that I have is that in recent months – since September – distributions have been mostly return of capital, rather than ordinary income.

The fund was previously paying 100% of distributions from income being generated but that is no longer the case. That does not mean it cannot become the case again, but anytime a fund is returning capital rather than income generated, it gives me pause in terms of sustainability. Again, I’m not suggesting SVOL will never get back to returning income rather than capital, but for now, I personally don’t like the look of this.

More tangibly, here’s a look at the distribution yield as of the end of November, against the SEC 30-day yield. The former is just the distributions divided by the share price, as you would see for any dividend stock. The latter is meant to provide a more comprehensive look at the actual yield of the fund’s earnings that are distributed to shareholders.

The SEC 30-day yield represents annualized net investment income earned by the fund over a 30-day period, then divided by the fund’s share price. In my view, this is an important distinction given the distribution schedule I showed above, and you can see the enormous gulf between the base yield and the SEC yield. A yield of 5%+ is still quite strong in the grand scheme of income vehicles, but it’s nowhere near the ~16% the stated yield gives. Each investor can make their own choice about this data but if you’re looking to generate income, 5.4% is much less attractive than 15.9%.

Wrapping up

Anyone that has read my work knows I generally lead with the price chart, but in the case of SVOL, it’s an income vehicle and the chart is less important. However, I did want to show the correlation of SVOL to the VIX, as a sort of test of how well the fund is doing in shorting the VIX.

We can see SVOL has been in a strong uptrend, and is indeed stable in terms of daily moves. The uptrend looks huge but spans only about $4 of share price movement over the past 10 months or so. That’s expected given the goal of the fund, and it’s achieving that.

If we look in the bottom panel, we have the 50-day correlation to the VIX, and we’d expect this to be very close to -1 given the stated goal of the fund. That’s generally true, but there was actually a period in August/September when SVOL and VIX had essentially no correlation. SVOL is an actively managed fund so it’s possible there are times when the stated objectives of the fund are temporarily unmet. On the whole, however, I think SVOL is well designed and is doing a pretty good job of meeting those design standards.

For me, though, with the VIX under 14 – which is fairly low – and the fact that SVOL hasn’t been achieving nearly the amount of income it did earlier in the year, I’m passing on SVOL. If the VIX were 20 or 25, I’d give a pass on the belief that the VIX would come down sufficiently to boost SVOL, but that’s simply not the case. For me, there are better places to put capital given the uncertainty surrounding the fund’s ability to finance its distributions with earnings. And finally, it’s expensive. SVOL charges 116 basis points for the privilege of owning it, which is about one-fifth of the SEC yield at the moment.

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