XYLD - XYLD: Making Sense Of Its Overlooked Factors

2023-09-05 07:32:33 ET

Summary

• The Global X S&P 500 Covered Call ETF possesses a few overlooked factors.
• Our analysis shows that much of the vehicle's returns derive from option premiums that flow through to investors via distributions.
• Key indicators suggest that the VIX might drift up soon, lending XYLD ETF the opportunity to capitalize on higher premiums.
• However, investors must consider that higher volatility can influence stock prices and attach basis risk to income from premiums.
• A sustainable dividend with low volatility was the kingmaker in our analysis, tipping the scale towards a buy rating.

The financial markets have been filled with action since the turn of the year; however, the stock market and volatility alike are trying to find direction after a period of cooling. As such, it is worth taking a look at the Global X S&P 500 Covered Call ETF ( XYLD ) , which is an exchange-traded predominantly driven by the broader market's price movement and volatility.

In today's analysis, we study the sources of return for the Global X S&P 500 Covered Call ETF. Moreover, an analysis of the ETF's efficiency is communicated.

Let's delve into the Global X S&P 500 Covered Call ETF's prospects.

Strategy Overview

I would encourage those of you who are unfamiliar with XYLD's strategy to visit this link to garner a better understanding of the vehicle's investment thesis, as a top-to-bottom explanation of option strategies is beyond the scope of today's analysis.

However, for those with a basic to advanced understanding, here's a brief reminder from our side.

The Global X S&P 500 Covered Call ETF provides investors with access to a covered call strategy, which sees it cover its long positions by shorting call options (going short). More importantly, by writing calls, the fund is a liquidity provider; therefore, it earns a premium on the call options from the buyer (the liquidity taker).

As a systemic risk seeker, the Global X S&P 500 Covered Call ETF uses a full S&P 500 replication technique and is usually short 100 % of its portfolio's value. In finer detail, the ETF tracks the CBOE S&P 500 BuyWrite Index, meaning its investors bet on systemic risk and portfolio manager skill instead of a novel diversification strategy.

What are the key factors behind the Global X S&P 500 Covered Call ETF's returns?

Fundamentally, the stock price, volatility, interest rates, and time are XYLD's key drivers. Moreover, volatility's key influence is echoed by option delta and gamma, whereby the prior measures the proportional change of an option relative to the underlying asset, while gamma measures the delta's rate of change.

Here's a breakdown of possible return outcomes

• Option Payoff = ST - MAX(ST - K) + P - S0
• Breakeven Price = S0 - P
• Maximum Loss = S0 - P
• Maximum Gain = (X - S0) + P

Denotations: ST = Stock Price at Maturity of Strategy; MAX(ST - K) = Stock Price - Option Strike Price; P = Premium Received from Writing the Option; s0 = Stock Price at Inception.

In essence, as a call writer who is long on the underlying asset, you want the stock to appreciate while volatility and interest rates settle below the estimates so that I can profit from the option's payoff rising less than the stock's payoff while remaining hedged. Or alternatively, you want the stock to depreciate less than the premium earned from selling the call while the buyer of the call ends up "out of the money".

For more information on covered call payoffs, visit the link provided earlier in the section or visit this link here , which leads to an insightful article.

Establishing Correlations

It is critical to understand how underlying factors influence an asset's total returns. As such, let's study a few of the Global X S&P 500 Covered Call ETF's return correlations.

Firstly, I have a correlation matrix for you, which shows the relationships between the ETF's monthly distributions, premiums earned, and price changes between September 2021 and July 2023.

It is evident that the Global X S&P 500 Covered Call ETF's distributions are highly correlated to income on premiums. The 1% monthly cap drags the number down a bit; however, the cap is beneficial at times as the retained dry powder allows the Global X S&P 500 Covered Call ETF to sustain high payouts in periods of low earnings.

Furthermore, distributions and the Global X S&P 500 Covered Call ETF's price changes are negatively correlated, as are the premiums earned versus the Global X S&P 500 Covered Call ETF's price. In our view, much of this stems from the inverse correlation between stock prices and volatility.

However, the correlation between premium availability and the Global X S&P 500 Covered Call ETF's price returns is somewhat weak. Thus, it is possible that the comparison can be overplayed at times.

For further context, I added the following diagram to provide a visual of the premium income versus distributions.

Lastly, a full representation of the premiums, distributions, and price fluctuations is shown below. An interesting observation from the panel data is the inconsistent volatility, which is expanded upon later in the article.

Our Near and Long-Term Outlook On Premiums

You ideally need an up-to-date outlook on the S&P 500 to assess the ETF's near and long-term prospects. However, with that being said, we can infer a lot by looking at the state of the ETF's exposure to volatility and interest rates.

Longer-term

The Global X S&P 500 Covered Call ETF takes on monthly bets with its call options, which is quite a low-risk way of executing the strategy as nearer-term options typically possess narrower premiums that are easier to forecast. As mentioned in the introduction, the vehicle is technically hedged against the S&P 500, but delta and gamma risk can throw this off balance at times.

As mentioned before, volatility is a key influencing factor, and the S&P VIX Index ( VIX ) has trended lower year-on-year with a steep decline in recent months. Thus, as things stand, the VIX suggests that realized volatility will settle low; however, the issue remains that the index's current data is likely already priced by the market. Therefore, as investors, we need to develop our own expectations.

In our view, the VIX might tick up in the next few quarters. Our claim is based on two facts.

Firstly, as far as I know, the VIX is not a random walk and is generally mean-reverting . If you look closely, the VIX is below its 1-year and 5-year simple moving averages. Therefore, a strong case exists that the VIX might drift higher in the coming quarters.

Secondly, the interest rate environment remains of concern. Robust inflation paired with a higher-for-longer narrative and an unsteady yield curve adds further substance to a higher VIX.

Higher interest rates generally support market volatility. Moreover, as illustrated below, volatility between the 2-to-10-year treasuries remains rife, which we think will sustain until more CERTAINTY about the U.S.'s interest rate cycle surfaces.

Let's imagine our prediction is realized.

Higher volatility might provide higher premiums on call options, which will likely benefit the Global X S&P 500 Covered Call ETF's investors. However, a more challenging hedging environment might present itself due to a concurrent rise in delta and gamma. Thus, if I were a Global X S&P 500 Covered Call ETF investor, I would be careful of "chasing premiums".

Short-term

The fund's current call exposure is centered on September 15 short calls.

In our opinion, solid hedging properties are available in this round due to gamma. Delta remains below 1, implying a lesser move in option prices for a move in the S&P 500. However, the gamma, which measures the delta's rate of change, provides a cushion.

A primary risk with short-term options is the unpredictability of the VIX in the short term; as such, investors must keep in mind that substantial losses are possible if the Global X S&P 500 Covered Call ETF's short-term VIX target is out of bounds.

Furthermore, as mentioned earlier, an outlook on the S&P 500 is required to fulfill the analysis. I recommend reading Seeking Alpha's thread on the SPDR S&P 500 ETF TRUST ( SPY ) to enhance your analysis.

Portfolio Risk-Return Attribution

Let's run through a few risk-return attribution measures, summarized in the diagram below.

Compared to the SPY, the Global X S&P 500 Covered Call ETF has a lower beta coefficient, which is likely due to half of its portfolio being hedged most of the time.

Although we think the ETF's conditional value-at-risk metric of 8.47% shows that it presents little tail risk, an excess kurtosis value of 4.58 suggests the Global X S&P 500 Covered Call ETF's tail risk losses occur frequently.

Furthermore, the fund hosts a negative information ratio stemming from its substantial tracking error and negative active return. Thus, the fund's portfolio managers can be called into question somewhat as it is underperforming its benchmark on a risk-adjusted basis.

Fund Distribution Record

Most of the Global X S&P 500 Covered Call ETF's returns derive from distributions, arguably making it an income-based pure play.

The fund's distributions are rather appealing, with its trailing dividend yield of 9.08% being accompanied by solid compound annual dividend growth rate numbers. In addition, referring back to our distributions chart embedded earlier in the article, the Global X S&P 500 Covered Call ETF's distributions are less volatile than its premiums earned, which we believe communicates dividend safety.

A final factor to consider is the ETF's cost, which is naturally quite elevated as the Global X S&P 500 Covered Call ETF is an actively managed fund with limited capacity to engage in cost-cutting features such as securities lending. Nevertheless, I think if we are all being honest, an expense ratio of 0.60% to obtain risk-adjusted exposure with high-quality dividends isn't overly demanding.

Final Word

Our analysis aimed to address overlooked factors relating to the Global X S&P 500 Covered Call ETF, which we believe is a highly actionable security in today's market environment.

Based on key variables and numerous data points, we conclude that the vehicle presents solid income-based opportunities. Sure, the uncertain interest rate environment does pose a threat; however, we think the ETF's concept is a lucrative tool to any investor seeking a diversification strategy while lifting his/her portfolio's income-based returns.

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