The Federal Reserve has indicated both through their actions (lowering the Fed Funds Rate three times in 2019) and through their commentary that they intend to keep rates relatively low in the near-medium term. While this is intended to be accommodating to the economy, it poses a challenge for institutions and individuals seeking to generate distributive income through their investments.
Investment grade bonds have been the traditional stalwart for providing both stability to an investment portfolio and a suitable amount of steady income to investors. However, in this low yielding environment, many investors are only looking to investment grade bonds as portfolio ballast and are forced to look elsewhere for yield. Traditionally, segments such as high yield bonds, bank loans, and high dividend paying stocks have been a source for income.
Each of these segments, however, carry significantly more risk than investment grade bonds and while loading up in these areas can make the yield look good on today’s investment statement, it may subject the portfolio to more dramatic losses of principal when markets turn out of favor. Income investors run the risk of being blinded by high yields and fail to realize the impact it may have on their total portfolio value.
As baby boomers continue to retire, the demand for income will continue to grow and could produce an unintentional bubble in these sources of income. As that bubble expands, spreads will tighten further limiting the income available as well as increasing the damage should the bubble pop.
There are other sources of income generation available outside of these common asset classes. We believe one of the most underutilized, but most consistent is through the use of an option writing overlay. In essence, an option overlay allows an investment manager to play the part of an insurance company within their funds, collecting premiums on a regular basis while periodically paying claims. As long as the levels of premium collected are higher than the amount of claims paid, a fund pockets the incremental income to pass along to its investors.
Option writing is an academically supported and market tested approach to income generation, but due to operational complexity, access to an option overlay strategy has traditionally been reserved for ultra-high net worth individuals and institutions. However, those barriers are beginning to break down. For example, our firm has been managing conservative option overlay strategies for many years and recently launched the Overlay Shares series of ETFs that packages traditional asset classes (e.g. stocks, investment grade bonds, etc.) with overlay focused on enhancing income into a single, easily accessible investment option for all investors. In a low yielding, and potentially low returning environment, investors may need to expand how they access income and the investment industry is evolving to deliver accessible solutions to meet those needs.
The assertions and statements in this blog post are based on the opinions of the author and Liquid Strategies. The examples cited in this paper are based on hypothetical situations and should only be considered as examples of potential trading strategies. They do not take into consideration the impact that certain economic or market factors have on the decision making process. Past performance is no indication of future results. Inherent in any investment is the potential for loss.
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Investors should consider the investment objectives, risks, charges and expenses of the Overlay Shares ETF carefully before investing. For a prospectus or summary prospectus with this and other important information about the Fund, please visit overlayshares.com or call (866) 704-OVLS. Read the prospectus carefully before investing.
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Risk Factors: The Fund invests in options that derive their performance from the performance of the S&P 500 Index. Selling (writing) and buying options are speculative activities and entail greater than ordinary investment risks. The Fund’s use of put options can lead to losses because of adverse movements in the price or value of the underlying asset, which may be magnified by certain features of the options. When selling a put option, the Fund will receive a premium; however, this premium may not be enough to offset a loss incurred by the Fund if the price of the underlying asset is below the strike price by an amount equal to or greater than the premium. Purchased put options may expire worthless and the Fund would lose the premium it paid for the option. The Fund may lose significantly more than the premiums it receives in highly volatile market conditions.
The Fund will invest in short term put options which are financial derivatives that give buyers the right, but not the obligation, to sell (put) an underlying asset at an agreed-upon price and date. The Fund’s use of options may reduce the Fund’s ability to profit from increases in the value of the underlying asset. The Fund could experience a loss or increased volatility if its derivatives do not perform as anticipated or are not correlated with the performance of their underlying asset or if the Fund is unable to purchase or liquidate a position.
The Fund was recently organized and has no operating history. As a result, investors have a limited track record on which to base their investment decision. Investments involve risk including the possible loss of principal.