SPY - XYLG: A Covered Call Fund That Offers 5% Yield And Some Upside

2023-08-19 05:51:20 ET

Summary

• Global X S&P 500 Covered Call & Growth ETF (XYLG) offers income generation and partial participation in the S&P 500 index upside.
• XYLG sells monthly at-the-money covered calls against 50% of its assets, offering a dividend yield of 4-7% depending on VIX (including SPY's dividend).
• The fund's performance is expected to outperform during bull markets and underperform during bear markets compared to XYLD.
• Since inception, the fund's performance matches that of SPY almost perfectly.

Global X S&P 500 Covered Call & Growth ETF ( XYLG ) is another covered call fund by Global X which is known for covered call funds such as Global X NASDAQ 100 Covered Call ETF ( QYLD ), Global X S&P 500® Covered Call ETF ( XYLD ) and Global X Russell 2000 Covered Call ETF ( RYLD ). The fund offers an interesting way of generating income while participating in some of the upside offered by the S&P 500 index ( SPY ).

This fund is basically a sister fund of XYLD and cousins of QYLG ( QYLG ) and RYLG ( RYLG ). The way the fund works is slightly different from XYLD because XYLD sells monthly at-the-money covered calls against SPY against 100% of its assets whereas XYLG does the same thing against 50% of its assets, so it basically offers half of XYLD's dividend yield while participating in 50% of SPY's upside. I say this fund is cousins of QYLG and RYLG because these two funds also apply the same approach to QYLD and RYLD respectively.

XYLG pays a monthly dividend yield of 4-7% depending on VIX. Last year when VIX was in mid-to-high 30s, it had a dividend yield slightly higher than 6% but this year the yield is closer to 4-5% range with VIX being in 13-17 range. This includes the addition of SPY's own dividend, which is currently around 1.45%.

The fund boasts a Beta value that ranges from 0.57 to 0.79 depending on which index you compare it against. Beta refers to how volatile a stock or fund is as compared to a benchmark index. A Beta value of 1.0 implies that a fund is just as volatile as its benchmark index but not more, whereas a Beta value above 1.0 implies that the fund is more volatile and any value under 1.0 implies less volatility. Basically, this shows how much this fund is expected to move for each 1% movement we see in the indices. Since XYLG's beta is 0.79, we can expect it to move up or down 0.79% for every 1% move in SPY, but this is only in theory since upside is capped for 50% of this fund's assets so if SPY were to jump 10% tomorrow (an extremely unlikely event but bear with me), XYLG would jump only 5%, implying a Beta of 0.5 due to part of it being capped.

When it comes to covered call funds, one of the biggest issues is NAV erosion. This happens when the market is highly volatile and worsens when there is a W-shaped market movement, and it affects funds that sell at-the-money calls the most. How? Let's say you have a stock that trades for $100, and you write at-the-money calls at exactly $100 and collect a premium of $2. Next month the stock drops to $85, and now you are down $13 including the dividend premium you collected. Then you sell $85 calls for another $2, but now the stock price climbs back to $100, and you miss all that upside. On the third month you sell at-the-money calls again at the strike price of $100 and the stock drops to $85 again. So in 3 months you collected a total premium of $6 (3 times $2) and you experienced two drops of $15 while not participating in the recovery that happened in the second month. Now you are down $24 whereas the stock you are following is down only $15.

The fund is passively-managed and uses a fully automatic approach to its call writing. Every month it writes calls exactly at the current strike price and holds it for a month until the call expires. Since the call is cash settled (European style), there is no risk for early assignment. There is no managing the call option and no rolling. If the fund sold $440 calls when SPY was at $440 and a few days later SPY quickly dropped to $420 or climbed to $460, the option sold by the fund would have almost no time value left in it, but the fund will still hold it until the end of the month instead of rolling it up/down for more premiums. To give another example, let's say the fund sold covered calls when VIX was 35 and VIX suddenly dropped to 15 and the call's premium dropped significantly. Most actively managed funds would close that call position for a profit and create new positions, but this fund won't since it's not actively managed. Once a call is written, it stays there until its expiration, no matter what happens.

XYLG can also experience NAV decay, but at a more limited scale, since it sells covered calls against half of its assets. In the above scenario it would have collected $3 in 3 months instead of $6, but it would have collected $7.5 in the second month when the stock is recovering from $85 to $100. Thus, its total loss would have been $19.5 instead of $24.

By design, XYLG is expected to outperform during bull runs and underperform during bear markets as compared to XYLD by design as it sells less covered calls to buffer a downside move but also happens to participate more in the upside. To have a better understanding of this, let us compare the performance of the two funds during the bear market of last year and the rally that started last October.

First, let's look at these funds on the way down. Last year from January to October, S&P 500 index was down by 24.3% whereas XYLD was down "only" 17% and XYLG was down -21%. Both covered call funds fell less than the index as they both enjoyed a buffer from selling covered calls, but that buffer was limited and didn't offer that much protection after all. I am somewhat surprised by this because I was expecting a larger protection because last year's drop was in an orderly fashion spanning over a period of 9 months, and we didn't really experience a sudden crash which covered call funds should have been able to use to soften the blow. Also, since VIX was in mid to high 30s for a good portion of the year, I would have expected these funds to generate enough premiums so give them decent amount of protection but looks like it didn't happen at a scale I was expecting.

Then came the rally after the markets bottomed in October. From the bottom of October 14, 2022 to July 31st, we saw S&P 500 index rally by 29%. In terms of total returns, XYLD was up about 18% which is a significant underperformance, but this is expected from covered call funds during a strong bull rally. Interestingly enough, XYLG was able to capture a big portion of SPY's upside by being up about 24% during this period. As a matter of fact, XYLG's performance falls exactly at the halfway between SPY and XYLD which is what one would expect. I'd also invite you to look at the left side of the chart from October all the way to mid-May, where the three funds had almost identical performance. From October to May, all three funds were up exactly by 16%. This is because the first part of SPY's rally came in an orderly fashion where it rose slowly, almost in a range. The second part of the rally came at an accelerating rate, so XYLD and XYLG missed part of the rally. Also keep in mind that during this period, VIX was dropping, which hurt the premiums received by XYLG and XYLD.

What happens when we combine the two periods, including the down and up period. It turns out that the funds had the same performance as SPY during this period spanning from January 2022 until August 2023 which included a 9-month-long bear market followed by a strong rally.

All in all, this is a decent fund, and it can also be used in combination of other funds to create different variations. For example, if you mix 50% XYLG with 50% SPY, you get a combination that writes covered calls against 25% of SPY (50% + 0%) / 2 )). If you combine this with XYLD, you get a combination that writes covered calls against 75% of SPY (50% + 75%) / 2)).

If we knew for sure that the market is going to rally hard next year, we'd put all our money into SPY. If we knew for sure that it will be a choppy year, we'd put it all into XYLD (especially if VIX is rising). The truth is, we don't know and we can't predict the future. This is why XYLG makes sense in uncertain environments, where you still collect a nice dividend while enjoying some upside.

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