ETFs Continue To Get More Sophisticated

A look at the increasing sophistication available through ETFs.

Today I wanted to take a quick look at a couple of newer ETFs. First though, the picture in the header of this post is from Zion National Park near Kanab, UT and Springdale, UT. We did a quick drive through last week on our way to Great Basin National Park in Northern, NV. It was our second time driving through like this and obviously the scenery is awesome but we haven't really done much in the park but hope to get to it soon.

Kurtis Hemmerling, writing for Seeking Alpha, clued me in to the CBOE Vest S&P 500 Dividend Aristocrats Target Income Fund (KNG). The term "dividend aristocrats" refers to companies that have increased their dividends annually for at least 25 years. There is an ETF that tracks this group of stocks; the ProShares S&P 500 Dividend Aristocrats ETF (NOBL). That a company can increase its dividend every year for X number of years is logically viewed as a favorable attribute indicating general corporate health as well as a growing business that allows for paying more to shareholders. The literature for KNG correctly notes that dividend growth doesn't necessarily mean that aristocrats have high yields. As I have looked at dividend centric ETFs over the years starting with iShares DJ Select Dividend ETF (DVY) when that first came to the market, the yields relative to the S&P 500 have been all over the place. ProShares' site for NOBL says the underlying index' yield is currently 2.53% which is nicely above the S&P 500, which these days has a yield around 1.82%, but isn't a high yielding dividend play.

KNG adds a option writing overlay to an aristocrats portfolio such that it tries to deliver "3.0% over the S&P 500 annual dividend yield," not the aristocrats' annual dividend yield. So for now the fund would deliver a yield in the 4.80's if everything goes to plan. It is important to note that it is limited to selling calls on 20% of each equity position but typically sells calls on closer to 10% of each equity position. Selling calls in this manner reduces the upside that is given away in the typical covered call strategy. If you buy 1000 shares and sell 10 call options, you are surrendering gains above the strike price of the calls and with KNG it is more like buying 1000 shares selling only one or two calls.

One of the comments on Hemmerling's article said something about buffering the downside with this strategy to which I would say "not so much." If the next bear market takes the S&P 500 down 30%, it seems plausible that KNG might be spared a couple of hundred basis points (but there is no way to know) and while that is better than the alternative, that still seems like full bear market participation. That doesn't mean the fund won't be a good hold, I just would not go in believing it would only be down 15% in a down 30% world.

One thing that might cause investors to balk is the 0.75% expense ratio. Adding a call writing strategy takes more time than managing a plain vanilla, large cap equity index fund and is going to be more expensive. The Horizons Nasdaq-100 Covered Call ETF (QYLD) has a 0.60% expense ratio but it sells index options, not options on individual stocks. Obviously someone not seeing value in the extra expense of the options overlay wouldn't buy the fund.

Yahoo Finance shows KNG paying only one dividend so far, the fund just started trading a few months ago, so it is too soon to draw any conclusions about its ability to meets that 3% above yield objective.

One final note is that KNG is philosophically pretty close to the context I've talked about with covered calls before which is thinking in terms of squeezing out an extra dividend or two during the course of the year. I think that is a conservative way to view covered calls as opposed to the idea that surfaces every few years about generating 3% per month selling calls. Run screaming from the room, waiving your arms frantically when you hear one of those pitches.

Recently, I briefly mentioned the Innovator S&P 500 Defined Outcome ETFs saying they are like structured products, I saw essentially the same strategy during my very brief stint at Morgan Stanley in 2003. A reader at Seeking Alpha, maybe not seeing that post, asked whether the funds were a scam or if there was something to them. I've read a couple of things about them but what these really are just sort of clicked in my head as I started to reply to the reader; these are essentially collars. I've not seen them described that way elsewhere but maybe they have been (I did not do a deep dive on the Innovator site which is linked above if you want to look).

The funds limit the upside and the downside which is what an options collar does. In a collar you buy the underlying stock or index ETF, you sell a call which limits the upside, then you take the proceeds from the call to buy a put which limits the downside. Very simplistically, the stock might be $100/share and maybe you sell a call struck at 115 and buy a put struck at 90. The short call/long put combo might be done for a credit, a debit or even money but you might see the term zero cost collar related to this strategy.

That the funds are essentially collaring the S&P 500 is neither good nor bad, more like it is something you need or it isn't something you need. From there, the 0.79% expense ratio is either worth it to you or it isn't worth it to you. The word collar is not in the prospectus (per a control F search) for the Innovator S&P 500 Ultra Buffer ETF (UJUL) but if you read the first paragraph, it seems to be describing a collar.

To the reader's question, I do not think it is a scam, but there are a lot of moving parts beyond the general context here and to the extent investing should be simple; whatever these are, one thing they are not is simple.

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