SVOL - SVOL: Simplifying Market Volatility To Generate Income

2023-05-30 02:21:26 ET

Summary

• Simplify Volatility Premium ETF (SVOL) offers a high yield income of over 17% based on current monthly distribution, taking advantage of market volatility.
• SVOL generates income from options premiums, holding the majority of its assets in safe havens like US Treasury Bills and Notes.
• Despite its short history and potential risks, SVOL has outperformed similar funds in the past year, making it an attractive option for investors seeking high yield income.

Market volatility is nothing new to long-term investors, but it can generate lots of nervous pessimism when it occurs, regardless of your investing prowess or longevity in the market. With recent bearish market action in March, many were expecting to see a sharp rise in market volatility. And that bump up in the VIX did in fact occur, briefly breaching the 26 mark, but has fallen back since to a more modest level below 18 as of market close on 5/26/23.

For investors seeking high yield income, increased volatility as expressed by the S&P VIX Index ( VIX ) can offer opportunity as well as caution due to the wild price fluctuations that can result. One fund that takes advantage of swings in the VIX (i.e., volatility of volatility) is an ETF that generates over 17% annual yield based on the current monthly distribution of $0.32, Simplify Volatility Premium ETF ( SVOL ).

From the fund Q123 fact sheet,

The Simplify Volatility Premium ETF ( SVOL ) seeks to provide investment results, before fees and expenses, that correspond to approximately one-fifth to three-tenths (-0.2x to -0.3x) the inverse of the performance of the Cboe Volatility Index ( VIX ) short-term futures index while also seeking to mitigate extreme volatility.

The fund managers use an option call overlay strategy to minimize the impacts and help protect against adverse moves (i.e., spikes in volatility) that may occur. One new tool that SVOL may benefit from is the latest offering from CBOE that tracks daily expectations of short-term volatility.

"We believe the VIX1D Index will be a useful tool for the growing group of investors utilizing same-day options trading strategies to better understand the daily market dynamics," said Rob Hocking, senior vice president and head of Product Innovation at Cboe.

Other analysts on SA have recently covered SVOL and they have mixed ratings based on their expectations of increasing volatility over the remainder of 2023. One analyst in an article on SVOL published in late April believes that market volatility will substantially increase later this summer. Another analyst feels that SVOL is too complicated and risky to invest in now. My recommendation is that for investors who are interested in a steady stream of high yield, monthly income from an alternative asset type of investment, SVOL is well worth considering. I rate the fund a Buy at a price below $22 and would look to accumulate shares whenever the VIX spikes and sends the price of SVOL lower. The inverse relationship between VIX spikes and the price of SVOL can be seen in this YTD chart of price return.

In April, even JPMorgan ( JPM ) warned that the VIX was artificially low, implying that a sudden shift in market sentiment could easily send the VIX spiking again.

In a note to its investors, the bank stated: “We believe the reasons for low volatility are technical in nature with the market dominated by option sellers. Selling of options forces intraday reversion, leaving the market price virtually unchanged many days. This in turn drives buying of stocks by funds that mechanically increase exposure when volatility declines.”

In actuality, the opposite has occurred in the month since JPM issued their warning. Another SA analyst opined on May 15 that improved market efficiency and a safer market structure could in fact subdue the VIX. In his conclusion, the author states:

It simply is rational to use more precise and efficient instruments to benefit from volatility; the VIX no longer has the same level of upside it did prior to the activation of the circuit breakers around the pandemic. Many have blamed 0DTE options for a suppressed VIX, but I view their increased use as a symptom of the shifting skew of SPX options caused by lessons that COVID-19 taught collective market participants about the nature of financial volatility.

How Does SVOL Generate Income?

The SVOL ETF uses 25% short VIX exposure along with deep OTM VIX call options to provide low-cost protection against VIX spikes. Most of the fund’s total assets are invested in US Treasury Bills and Notes as shown in the fund’s semi-annual report dated 12/31/22.

To offset future spikes in the VIX, the fund held 4,800 in January call options contracts and 6,000 in February contracts.

Open short positions on VIX futures were also shown in the report:

Current holdings on the fund’s fact sheet as of 3/31/23 indicate that they had over 17% cash and less in Treasuries than they held at the end of 2022.

Because SVOL holds the majority of its assets in safe havens like Treasuries and cash, the NAV does not fluctuate all that much over time. The income is generated almost entirely from options premiums allowing the fund managers to distribute a steady monthly distribution that does not vary from month to month. For the first few months of the fund’s history since it went public in May 2021, the distribution was variable, but has remained constant since May 2022, with the exception of an increased distribution in December 2022, as shown in the Dividend History page from SA.

With only 2 years of history there is not a lot of back testing that can be helpful in understanding how the fund might perform in a significant market event like the 2008 GFC or the 2020 Covid pandemic. However, for the past year and since inception, the fund has performed quite well as shown on the fund fact sheet.

In the fund literature, the Q123 Quarterly Fund Review summarizes the quarterly performance results and an outlook on future return potential.

SVOL returned 3.84% this quarter, as compared to 7.48% from US large cap equities, which is in line with expectations for an income strategy that is more likely to potentially sustain these levels of returns. Short positions in VIX futures contributed positively, with VIX declining from 21.7 to 18.7 and the VIX futures curve consistently being in strong contango (upward sloping). The cost of hedging by VIX call options was almost completely offset by the income generated by cash invested in short-term fixed income investments. Low volatility of volatility continued to allow the purchase of option hedges at relatively cheap prices.

The level of VIX is moderate, however, the roll yield in the futures is well above historical average due to the demand for VIX being significantly higher than the supply. In such market conditions, SVOL has the potential to deliver higher returns per unit of risk as compared to US large cap equities and other equity income strategies.

While it may seem complicated to generate income from options premiums that include both short positions on VIX futures, as well as call options overlays for hedging purposes, the strategy makes a lot of sense if the timing of those options contracts is well managed. As Simplify explains on their website , the non-linear behavior of options allows them to scientifically approach innovative yet simple solutions to enhance investors' portfolios.

The non-linear behavior of options allows us to extend common betas like equities and duration into much more nuanced market exposures. But options can get complex quickly. By scientifically approaching how options can help modify common betas, and simplifying these solutions for easy adoption by advisors, we provide innovative yet simple solutions that can help advisors build better portfolios.

They have in essence applied their own investment philosophy into many of their product offerings including SVOL. Simplify was founded in 2020 and offers quite a few ETFs in addition to SVOL. A complete listing of those ETFs can be found here . As they state on the ETF lineup web page, their funds are designed to directly and efficiently hedge portfolios against interest rate risk while generating managed income with exposure to alternative asset classes.

More About Simplify

Simplify also publishes podcasts, videos, and webinars explaining their fund strategies, market outlook, etc. In one of those published webinars on the April Market Strategy update, co-founder and CEO Paul Kim along with Chief Strategist Michael Green discuss their outlook on the 2023 market. One takeaway that I got from listening to that webinar is that the recession that everyone has been expecting in 2023 may have already started in March with the collapse of Silicon Valley Bank.

That could mean higher volatility in the market and a rise in the VIX is coming soon. On the other hand, with the potential resolution to the debt ceiling debate coming to closure in the next few days, we may see improved market action in June and potentially in the second half of 2023 as a lot of the liquidity sitting on the sidelines begins to come back into the equities market.

If there are signs that the US is already in a recession, that may indicate that the Fed needs to put the brakes on raising rates further, which could be the capitulation that many investors have been waiting for to re-enter the market. Either way, I think that the next few weeks will offer a good indication of what future volatility in the markets will look like for the rest of 2023. My guess is that the SVOL fund managers will be busy modeling the various scenarios with their fingers on the pulse of the VIX ready to write more options contracts and they have cash ready to invest.

Co-founder and CEO Paul Kim built a $3 billion ETF business as portfolio manager for Principal Global Investors prior to starting Simplify and was a senior VP and product manager for Pimco before that. The other co-founder and CIO of Simplify is David Berns, PhD, who was most recently founder and inventor of Portfolio Designer, a cloud-based asset allocation platform for building customized portfolios. Together they have created a new ETF portfolio that utilizes quantitative methods to address the most critical portfolio challenges by intelligently deploying options.

Comparison to Similar Funds

There are several other funds available to investors that utilize options to generate income from premiums on covered calls or other similar strategies. For example, the Global X S&P 500 Covered Call ETF ( XYLD ) uses a covered call strategy to generate premiums from covered calls on SPY options. As one analyst recently suggested , that premium income is dropping as the VIX drops which is resulting in a reduced distribution by XYLD in 2023.

Because SVOL primarily generates the bulk of its income from shorting VIX futures, the distribution is easily maintained as the VIX falls and even higher premiums are collected by the fund. If the VIX were to begin to reverse course and climb again, the XYLD fund should be able to collect higher premiums than SVOL and it would benefit more. If an investor were comfortable holding multiple funds that generate income from options premiums, it would potentially be wise to hold both funds to take advantage of swings in both directions in the VIX.

Another popular fund with income investors that utilizes option strategies to generate income is JPMorgan Equity Premium Income ETF ( JEPI ). Like XYLD, JEPI uses an actively managed covered call strategy along with ELNs (Equity Linked Notes) to generate a high yield distribution. In his article from earlier this year, Brad Thomas does a good job of explaining how JEPI generates income. JEPI currently yields about 11.5% and is benefiting from the generally sideways market action in the SPY so far in 2023.

In comparing the 3 funds, I looked at the total return for the past 1 year using the Charting tool in SA.

It is quite apparent that SVOL is the clear winner over this time frame with a one-year total return exceeding 15%. I believe that a big part of the reason why SVOL has performed better is because the VIX has been in a decline for most of the past year, and especially for the past 6 months as shown in the chart at the beginning of this article.

SVOL does not come without risk. The fund has a short history and has not yet been tested by a major market meltdown. And even though 2022 was a challenging year for most asset classes it did not pose a huge risk to the SVOL options strategy because the VIX did not spike dramatically. If that were to occur, for example, if the economy were to collapse suddenly and the VIX spiked significantly like it did in March 2020, then SVOL could experience a dramatic drop in price as well as experience difficulty covering the distribution. If you think that scenario is likely to happen again this year, then I would avoid investing large amounts of capital into funds like SVOL.

If you believe, as I do, that we have already begun to see the resumption of a bull market in 2023 after suffering a disastrous year in 2022, then SVOL could be an excellent place to park some cash to generate a steady stream of income for the future as part of an income compounding portfolio. I hold a substantial position in SVOL at an average cost of about $22 in my No Guys No Glory IRA portfolio . I also hold smaller positions in JEPI and XYLD among other high yielders. If you are risk averse and prefer to collect 5% yields from safe money market accounts or bonds, then this fund may not be in your wheelhouse.

For further details see: