By Charles Lynn Bolin

It’s a good practice to take a thorough review annually of investment performance including fees and taxes. A dual-income household may accumulate a half dozen or more accounts because of tax characteristics, ownership, and goals. A good way to start is to list the accounts in order of planned withdrawals. The next step is to make sure that each account has the appropriate amount of risk and that the assets within are tax-efficient for the type of account. I am in the process of converting Traditional IRAs to Roth IRAs and the conversion is taxed as ordinary income. Municipal Bonds are included in Modified Adjusted Gross Income and may impact Medicare Premiums (IRMAA). In after-tax accounts, income is taxed while stock appreciation is not until sold and then often at lower capital gains rates. This is known as the Bucket Approach.

Our review found that we were paying over one percent of assets to have one special purpose, after-tax account managed with a 50% Stock to 50% Municipal Bond Ratio. It is a relatively small, but significant account that I had set up during uncertain times to be tax efficient. In the hierarchy of withdrawals, it will be the last account tapped. The appropriate goal for this account is for capital appreciation and simplicity while minimizing taxes. I use Fidelity and Vanguard wealth management services for some of our investments, and in the context of overall portfolio management, I am looking for a single tax-efficient equity fund to “buy and hold” for this account.

This article is divided into the following sections:

• Section 1, Investment Objective
• Section 2, Search Criteria
• Section 3, Summary of Lipper Categories
• Section 4, Short List of Tax-Efficient Funds
• Section 5, Final List of Tax-Efficient Funds
• Section 6, Vanguard Tax-Managed Capital Appreciation Admiral Fund (VTCLX)

Investment Objective

Collectively, my investments resemble a 60% stock/40% bond diversified portfolio, in part because I have pensions and Social Security to cover most living expenses and can withstand down markets. I concentrate Bucket #1 (Living Expenses) on short-term cash equivalents such as municipal money markets and bonds. Bucket #2 is mostly Traditional IRAs where taxes are yet to be paid and which have higher allocations to taxable bonds. Long-Term Bucket #3 consists of Roth IRAs and After-Tax Accounts which are concentrated in equities that are tax-efficient if held for the long term or using tax loss harvesting.

My goals for this one fund are 1) to have high after-tax returns, 2) to minimize income and taxes, and 3) to have respectable risk-adjusted returns as measured by the MFO Rating. This typically means an equity fund that pays low dividends and has low turnover.

Search Criteria

Table #1 shows the criteria that I used for the initial search. I restricted the mutual funds to Fidelity and Vanguard. While volatility is not a major consideration for this fund, I wanted to eliminate the most volatile funds.

Table #1: Search Criteria For Tax-Efficient Funds

Summary Of Lipper Categories

After a process of elimination, the search resulted in 32 mutual funds, and eighty-four exchange-traded funds in twenty-three Lipper Categories as shown in Table #2. The categories are sorted from the highest five-year After-Tax Annualized Return/Ulcer Index. The Ulcer Index is a measure of the depth and duration of drawdowns. The top section shaded in blue contains the Lipper Categories that I am most interested in, but I also want to consider global funds from the middle section.

Table #2: Tax-efficient Lipper Categories

Short List of Tax-Efficient Funds – Five-Year View

I then went through the funds in each of the Lipper Categories and selected one or two based on after-tax return, fund family rating, and tax efficiency, among other criteria. The nine funds in Table #3 are outstanding tax-efficient funds.

Table #3: Short List of Tax-efficient Funds – Five Years

Figure #1 shows the five-year performance of these funds. The two global funds have underperformed, but this doesn’t concern me because of stretched valuations in the US.

Figure #1: Performance of Short List of Tax-efficient Funds – Five Years

Final List of Tax-Efficient Funds – Ten-Year View

I then looked at the funds over a ten-year period. All of the funds in Table #4 are outstanding, but I favor Vanguard Tax-Managed Capital Appreciation (VTCLX) and WisdomTree US Quality Dividend Growth (DGRW). Figure #2 shows the ten-year performance of these funds.

Table #4: Final List of Tax-efficient Funds – Ten Years

Figure #2: Performance of Final List of Tax-efficient Funds – Ten Years

Vanguard Tax-Managed Capital Appreciation (VTCLX)

I decided to invest in the Vanguard Tax-Managed Capital Appreciation Admiral Fund (VTCLX). The link to the documentation is here. Figure #3 shows how VTCLX compares to other Vanguard funds for After-Tax Returns versus Downside Deviation. It has high after-tax returns but roughly matches the total market for volatility.

Figure #3: APR After-Tax Pre-5Year Versus Downside Deviation

Product Summary

“As part of Vanguard’s series of tax-managed investments, this fund offers investors exposure to the mid- and large-capitalization segments of the U.S. stock market. Its unique index-oriented approach attempts to track the benchmark while minimizing taxable gains and dividend income by purchasing index securities that pay lower dividends. One of the fund’s risks is its exposure to the mid-cap segment of the stock market, which tends to be more volatile than the large-cap market. Investors in a higher tax bracket who have an investment time horizon of five years or longer and a high tolerance for risk may wish to consider this fund complementary to a well-balanced portfolio.”

Fund Management

Vanguard Tax-Managed Capital Appreciation Fund seeks a tax-efficient total return consisting of long-term capital appreciation and nominal current income. The fund tracks the performance of the Russell 1000 Index—an unmanaged benchmark representing large- and mid-capitalization U.S. stocks. The advisor uses portfolio optimization techniques to select a sample of stocks that, in the aggregate, reflect the characteristics of the benchmark index. The technique emphasizes stocks with low dividend yields to minimize taxable dividend distributions. In addition, a disciplined sell process minimizes the realization of net capital gains and may include the realization of losses to offset unavoidable gains. The experience and stability of Vanguard’s Equity Index Group have permitted continuous refinement of indexing techniques designed to minimize tracking error and provide tax-efficient returns.

Table #5 contains the fundamentals for VTCLX and Table #6 contains the sector allocations.

Table #5: VTCLX Fundamentals

Table #6: VTCLX Sector Allocation

Closing

Over the next ten years, converting this 50% Stock/50% Bond account to DIY with one equity fund should result in saving thousands of dollars in fees, increase returns, and reduce taxes. It fits into an overall balanced portfolio and meets my objectives of keeping it simple. Currently, this account has a mixture of quality ETFs. I will gradually convert them over to the Vanguard Tax-Managed Capital Appreciation (VTCLX) when market conditions are favorable.

By Devesh Shah

Introduction:

In the March 2024 MFO, I introduced the two main developments in Options in recent years.

Zero-Day Options and Options-Based Funds. We learnt about the history of options, the market players involved and benefitting from Options, and started getting deeper into the Funds.

In April MFO, through the 2^nd and 3^rd articles in the series, I hope to dive deeper into Options-based funds.

In this article, I want to understand the motivations of the investors in these funds and of the fund managers involved. We want to look at a small selection of these funds qualitatively so we can appreciate the diversity within the Options Based Fund universe.

From Stocks & Options to Options-based Funds

Options buyers have one of two goals in mind: leverage or protection.

Option sellers are on the other side of this coin. By underwriting protection or leverage, option sellers are rewarded with option premium, which is repackaged and called “income” by some. 

Options-based funds have two components:

1. The first is to pick an equity sleeve: S&P 500 Index, Large Caps, Value stocks, Nasdaq, Actively Managed or Passive, etc.
2. The second is to repackage the three themes of options market players: leverage, protection, and income.

Every Options fund is a combination of an Equity Sleeve and an Options strategy.

A Twist in Time

Equities are considered permanent instruments. If a company survives in its current form, the stock lives on permanently. Once an investor buys a stock, there is nothing further to do to preserve the status as a partial owner of the enterprise and earn its profits and dividends.

Not so with Options. Each Option comes with a time frame. Zero-day options literally expire the same day (0 days). A 1-year option expires after a year, etc.

A Twist in Strike/Price

An investor is a long stock at whatever price they buy the stock.

Not so with Options. Each Option comes with a Strike Price. At the Option expiry, one compares the Strike price of the Option vis-à-vis the then Stock price to determine if the Option expires in-the-money or out-of-the-money.

Options-Based Funds: All this activity must mean Options Funds are Active Funds

Options-based funds have to make 4 choices (maybe 5 choices)

1. What’s the equity sleeve going to be?
2. Is this fund going to provide leverage, offer protection, or earn income?
3. What’s the maturity of the options expiry the manager chooses?
4. What’s the strike price of the options the manager chooses?

The 5^th choice: Should the options traded match the Equity sleeve?

But why do we need Options Based Funds? (a) Financial Democratization

Despite the exponential increase in options volumes over the decades, many investors have not participated in options. The jargon, the pricing, the trading and execution, and a host of other obstacles have kept investors away.

The goal of the management teams offering Options-based funds is to continue on the journey of options democracy. If professional fund managers can offer their options skills, end investors might get the benefit from the power of options without paying the cost of education. Instead, the cost is paid through a fund management fee. This is not much different than Active or Passive Funds charging investors a fee to put together a long Equity or long Bond portfolio we call a “fund”.

As the chart below shows us, Options-based funds have picked up momentum starting in 2018. The Y-axis shows the number of Options funds with current assets greater than $50mm started in each year.

But why do we need Options Based Funds? (b) A different way to achieve Portfolio Smoothing

Many of the readers will be familiar with a 60/40 Stock-Bond portfolio. When Stocks zag, the hope is that Bonds will zig. Together, the portfolio will be smoother. By diversifying across asset classes (stocks and bonds), and within asset classes (portfolio of stocks), an investor hopes to earn the risk premium embedded in asset classes while smoothening the ride.

Options Based Funds offer yet another approach to Portfolio Smoothing: 10 funds close-up

I asked @yogibearbull to define Beta of an ETF/(stock portfolio) to our readers.

He wrote, “beta of an ETF comes from linear regression of monthly returns with monthly benchmark returns (SP500 for US equity funds). Beta is the slope, or short-term volatility; alpha is the intercept, or manager’s magic. An ETF with beta of 0.80 means that if SP500 went up +1% that day, the ETF will likely go up +0.80%.”

Broadly speaking, the lower the beta of a portfolio, the lower the volatility. While a 60/40 lowers the portfolio’s overall beta through the negative correlation between stocks and bonds, Options funds lower the beta through the selection of the Active Sleeve and the Options strategy.

For example, JHEQX, the JP Morgan Hedged Equity Fund, an $18 Billion fund, has been around for 10 years. Here are the annual betas of this fund according to Portfolio Visualizer:

Year	2014	2015	2016	2017	2018	2019	2020	2021	2022	2023	2024 ytd
Beta	0.56	0.48	0.61	0.24	0.39	0.53	0.30	0.45	0.41	0.55	0.43

The Beta of JHEQX to the S&P 500 has never been higher than 61%. In fact, the average Beta of the fund since 2014 has been 43%.

Thus, this fund would never make 100% of the returns of the S&P on the way up AND would never lose as much as the S&P on the way down.

For many investors, this lower beta is IMPORTANT. Why?

To be candid, investors want to both be in US equities and not fully committed. Investors are willing to trade off some return for a smoother path.

Options Based Funds thus offer the promise of smoother returns.

The Many Shapes and Sizes of Options Funds:

	On S&P 500	On NDX	On Singles	On Global
Overwriting/Income	JEPIX/JEPI, GATEX, GSPKX, DIVO	JEPQ, QYLD	TSLY, NVDY, YieldMax ETFs	EXG, ETW, BOE
Hedged Equity	JHEQX, JHQDX, BUFR	CIHEX
Put underwriting	GLSOX, IRONX

This table is another way to show the different strategies employed by Fund managers and the different equity sleeves. There are over 300 funds, so, this is just a gross classification. Each fund is built differently. 

By Size

These are 23 funds with over $1bn USD AUM. I’ve created a table with the top 36 funds with assets of $600 million and higher.

Take a close look at the 4^th column labeled APR (Annualized Percent Return).

Some funds like RYLD (Fund #20) have returned only 3.02% a year.

Others like JEPQ (Fund #3) have returned 17.59% per year.

We also see that Yields (5^th column) and Sharpe ratios (6^th column) vary dramatically across funds.

Options funds are quite different enough in their make-up, which explains the differences in Returns, Yield, and Sharpe Ratios.

One thing we can rely on to be similar for all these funds is an Expense Ratio that’s more in line with Actively Managed funds. 83bps average of all the funds in the group excluding the largest ETF, JEPI (Fund #1), which has a reasonable expense ratio of only 0.35%.

Let’s take a closer look at some of these funds. I’ve tried my best to capture the essence of the funds. I am taking a little liberty with the details to keep us moving:

1. JEPI and JEPIX: JP Morgan Equity Premium Income (#1 and #6 above)

The Open-ended fund, JEPIX was launched in Sep 2018, and the ETF, JEPI, in May 2020. Together they hold almost $39B in assets. While the stock portfolios are slightly different between the fund and the ETF, they are the same to us. JEPI has a lower Exp. Ratio than JEPIX.

The funds hold a low beta, low volatility stock portfolio. They intend to pick stocks actively and hold about 130 stocks (not the 500 stocks in the S&P 500). Each week, the fund sells an ~2% Out-of-the-money call on the S&P 500 on ~ 20% of the Notional portfolio.

Such a fund employs a strategy known as “Covered Call Overwriting”. By selling calls on 80% of the portfolio at any given time, they hope to earn income from the option premiums. Along with the dividend earned on the underlying stocks, these funds have a high distribution rate of between 8 to 12% since inception.

Why does this fund attract money: Investors like steady distributions from dividends and call premiums. They like the idea of picking stocks that have a lower beta than the SPX. Investors understand their upside is capped in exchange.

2. DIVO: Amplify CWP Enhanced Dividend Income ETF (#10 above)

DIVO with $3B in Assets also uses a Covered Call Overwriting. It has even fewer stocks in the portfolio (28 stocks). DIVO writes 1month call options on some of these stocks (about 7 or 8 stock options).

We start seeing how these products differ. One writes calls on the S&P 500 Index, and the other writes call options on some individual stocks.

One holds a low beta portfolio of 130 stocks, the other holds only 28 stocks.

3. GSPKX: Goldman Sachs US Eq Dividend and Premium (GSPKX) (Fund #9)

Been around since 2005 with assets of about $3.5B. This fund is a Covered Call Overwriting similar to JEPI/JEPIX. It holds 280 actively picked stocks and sells Call Options on the S&P 500 Index. The fund tries to preserve the upside by overwriting ~40% of the Notional portfolio. When future volatility is high, and call prices are thus higher than average, the fund may sell as little as only 15% of the Notional in call options.

4. BDJ: Blackrock Enhanced Dividend Trust (Fund # 17)

This is one of various Blackrock funds that offers call overwriting along with long equities. 80% of the $1.7 Bn fund is invested in US Equities and the remaining 20% in the UK and Europe. This fund’s equity sleeve holds more than just US stocks, which makes it different than the funds above. The fund overwrites a part of the portfolio by selling 1-2 month calls on a fraction of the stocks. Like many other overwriting funds, Blackrock’s Investment approach for this fund is built on 3 pillars: Portfolio built on Dividend growth, Focus on High-Quality Companies, and Seeks to Reduce Portfolio Volatility.

5. JEPQ: JPMorgan Nasdaq Equity Premium Inc ETF (Fund #3)

As the name says, the fund is the Nasdaq 100 equivalent of JEPI and JEPIX (Fund #1 and Fund #6). The underlying stocks are Nasdaq 100 stocks (it actually holds 87 stocks and Nasdaq futures) and it writes call options on the Nasdaq 100 Index. The fund has $11.4B in assets.

6. QYLD: Global X NASDAQ 100 Covered Call ETF (Fund #4)

Similar to JEPQ in that the fund holds Nasdaq 100 stocks. It sells a 1-month Nasdaq At The Money Spot calls (that is, each month it sells a call on the Nasdaq close to the level of the market at the time of trading the call option). QYLD has $8.1B in assets.

Each of these funds is a painting. The fund manager decides which underlying stocks to buy, hopes they have some alpha in stock picking (or they might own the passive index), collects dividends, decides whether to sell call options on the S&P 500, on the Nasdaq 100, or on a small section of the stocks, what percent of the notional portfolio to overwrite, and the length of these options. Given the Assets held by these funds, it’s safe to assume that people want to invest in these call overwriting, income-generating, funds.

I’ve only pointed out a few of the larger buy-write funds focused on US stock portfolios. There are similar funds on Emerging Markets, on International Indices, and on Global Indices. Almost every bank offers their clients direct exposure to buy-write strategies through Over-the-counter structured products. The sizes involve dwarf the sizes in these listed funds. Before we close out the buy writes, I’d like to point out a fund strategy that is starting to accumulate assets quickly.

7. YieldMax ETFs: TSLY, NVDY, APLY, CONY, OARK… (not in the table above)

These funds own just one stock or ETF each – Tesla, NVIDIA, Apple, Coinbase, ARKK, etc. Each week they write out of the money call options expiring on the coming Friday.

Their idea is to take the call overwriting and the distribution from option income to the extreme. As an example, NVDY, YieldMax™ NVDA Option Income Strategy ETF, a $ 300mm fund holds $300mm of NVIDIA stock and sells $300mm of weekly calls. Over a year, if volatility stays high, the fund will overwrite NVIDIA 52 times (52 weeks). The distribution rate will be 109.59% (that is if you take what the fund pays out in income from options sold and multiply by 12).

TSLY, YieldMax™ TSLA Option Income Strategy ETF, has an annualized distribution rate of 62.7%.

What’s going on here? There is a lot of options speculation. Billions are being spent on Options by all stripes of investors. This fund wants to sell to those buyers. There’s now over $2B in the over 15-20 ETFs offered by this fund family.

A recent article pointed to 2 approved ETFs that will overwrite Zero-day options daily. If you like weekly overwriting, you are going to love daily!

Moving on, we next look at some Hedged Equity Funds now.

How is a Hedged Equity fund similar to and different than the Call Overwriting funds?

The similarity is in the Equity sleeve, or the underlying stocks, indices, or baskets held by Hedged Equity Options fund. Just as the Overwriting funds could own either the S&P 500, or the Nasdaq, or a small group of stocks, or an international index, the same goes for Hedged Equity funds. They could be passive or actively picked stocks.

The difference is how the two categories use Options. Overwriting funds only sell calls. Hedged Funds use Options to provide a downside buffer. Many funds are buying Puts or Put Spreads to control the losses of the Equity Portfolio. Most of these funds will sell Calls to finance some or all of the costs associated with buying the Puts or Put Spreads.

By adding Puts/Put Spreads, the fund manager hopes to dampen the effects of selloffs on an equity portfolio. For some investors, smooth returns are more important than large returns. Although it is the job of equities to generate volatility on the way to earning compounded returns, not everyone can take the volatility punches.  

8. GATEX: The Natixis Gateway Fund has been around since 2001 (Fund #5)

This $ 6.5B AUM fund owns 219 actively picked Stocks + a put collar. A put collar is a combination of long put and short call.

The fund sells ~ 2-month S&P 500 call options, which are ~2% out of the money (that is, 2% above the market level at the time of selling the options), and it does so on 95% of the notional value of equities held.

The fund also holds Put Options on about 95% of the portfolio. The fund has bought puts on the S&P 500 Index, which are ~ 2 ½ months out and ~ 6.5% below the market level.

9. JHEQX/JHQTX/JHQDX: JPMorgan Hedged Equity, Hedged 2, & Hedged 3 Fund (Fund #2, #7, and #13)

These are three different JP Morgan funds, very similar to each other, and separated only by a small twist. Together, they have $25 Billion in Assets, making them one of the biggest strategies in the market. All 3 funds hold around 170 US large-cap stocks (thus, actively managed).

If we dive deeper into one of the funds, JHEQX, which has been around since 2014, we see the fund owns a “Put-Spread-Collar” (PSC). The fund owns a 3-month hedge by buying a 95% Put, selling the 80% Put, and financing this Put-Spread with a Call so the out-of-pocket is zero at the time of the trade. This Strike of the call depends upon the cost required to purchase the 95-80 Put Spread.

The idea is that an investor in this fund:

1. Holds Actively Managed Large Cap Equities (more or less like the S&P 500)
2. Earns the dividend
3. Takes the stock market risk for the 1^st 5% of the portfolio
4. Is protected starting 5% all the way to 20% sell-off in the market
5. Then, takes all of the downside once again after 20%
6. Caps Equity upside at approximately 6% from the current level

JHEQX executes this Put Spread Collar every 3 months in Dec, March, June, and Sep.

The other funds, JHQTX and JHQDX, do it Jan, April, July, October and Feb, May, Aug, Nov respectively. There are no other conceptual differences between these funds.

Having $25 Billion in a strategy is no joke. This tells us that the market yearns for a product like this. Thus, we now see hundreds of funds that offer some kind of “Hedged”, “Buffered”, “Capped”, “Protected” in their investment mandate.

10. BUFR: First Trust FT Vest of Buffer ETFs (Fund #8)

A final example of a Hedged fund is BUFR. The ETF itself is made up of 12 monthly ETFs, so it’s a fund of funds. It owns an equal 8.33% weight in funds FJAN, FBEB, FMAR….FDEC.

FJAN is itself made up of only four 1-year options. If we peel the union FJAN is:

1. Long the S&P 500 Index (it does this through options)
2. Long a 100-90 Put Spread (as opposed to the 95-80 Put spread we saw above)
3. Short a Call 13-14% above the market

Because it holds no stocks at all and replicates its long S&P 500 Index exposure through Options, there are some funky things this FJAN and thus BUFR can do which improve tax treatments for a very specific group of investors.

FJAN alone has $750 million in Assets and BUFR has $3.5 Billion in assets.

The same fund manager offers Buffer, Moderate Buffer, and Deep Buffers for every single month and tens of other ETFs.

Diversity of the Many

Each of these funds is a painting. The fund manager decides which underlying stocks to buy, hopes they have some alpha in stock picking (or they might own the passive index), collects dividends, decides whether to sell call options on the S&P 500, on the Nasdaq 100, or on a small section of the stocks, what percent of the notional portfolio to overwrite, and the length of these options. In the Hedged funds, the manager will want to own puts or put spreads along with all of the above.

Conclusion

The goal thus far in the article was to pick out some large funds and show how they are similar and different to each other. I hope the reader has a sense of the diversity in these funds.

Diversity and variety are a good idea, but does it make money? Is it financially good? How can we compare such different funds to decide if they are a smart investment?

We hope to look at that in the 3^rd article.

By Devesh Shah

Having looked at the qualitative rationale for why options-based funds are offered by fund managers and sought by some investors, it behooves us to quantitatively analyze options funds’ performance. There is no ONE BENCHMARK that can be used to compare ALL the options funds. That may be a good thing. It’s made me think of what a good way to create a customized benchmark for each fund might look like. The benefit of keeping things focused on the small picture is we can look at one fund at a time, in detail, without drawing too many generalizations.

Challenges with option fund performance comparisons

The majority of option funds have only been around for a few years. This creates challenges in evaluating their performance. For example:

1. It’s not possible to run 10, 20, or 30-year analyses on a large enough sample of these funds and we cannot evaluate the funds as an Asset class.
2. Diversity within the options-based funds makes it difficult to compare any 2 funds. One of the goals of the accompanying article was to point out the different types of Equity sleeves and the differing choices made by fund managers. We can’t compare Large-cap Tech stocks to small-call International value stocks any more than we can compare option income/premium funds to hedged equity funds. Add the funky new class of funds that carry just one stock and overwrite daily or weekly options. There is NO PEER group here. Peer Averages mean nothing.
3. The last major 50% equity market crash was in 2007-2009. Most of these funds didn’t exist in that crash or the 2000-2002 50% crash. We don’t know how these funds will perform in the next major crash. (PS: There will always be a next major crash no matter how good everything looks at the moment).
4. The importance of observing active option portfolios through a stock market crash (even bearish portfolios) is to learn how the fund manager deals with coincident problems of illiquidity, high transaction costs, and volatility to get in and out of stocks and options. Derivative markets need deep liquidity in underlying stocks. In crashes, when this liquidity disappears, derivative market makers simply walk away or show absurd prices. How will that affect options funds? We don’t know yet.
5. When funds have a young age, their performance records are dictated by the timing of the launch and not necessarily the long-term merit of a strategy. There is no need to get too excited about every new options strategy. Active equity picking, high fees, and the burden of trading a large number of derivative contracts all add up as costs. Options exchanges and options market makers are raking in tons of revenue. Who’s paying for it? Don’t look around. It’s all the money going into Zero Day options and options funds.

Challenges with option fund performance comparisons: the S&P 500 is an unbeatable index

When I am introduced to any new US Equity linked fund, my first instinct is to compare it to the S&P 500. Is the fund unique in any way that can help my portfolio grow?

Comparing equity options funds to the S&P 500 (or the Nasdaq 100 where applicable) yields predictably disappointing total results.

To understand why, we must focus on Fund Betas.

The S&P 500, that is, the market in US equities, by definition has a Market Beta of 1.

The Betas of most of these options funds (orange squares in the chart) are lower than 1 (the S&P 500 marked by the Green mountain range).

Since US equity markets have gone up over the years, a lower beta = lower market exposure = lower total returns.

It’s important to capture the proper window for calculating returns. I’ve tried to do that below.

Using the narrow list of funds we qualitatively described in the accompanying article, I show each fund’s launch date (Column 4) and the evaluation window (Column 5). Then, in Column 6, I look at the Annualized return of the fund since that date and compare it to the Annualized Return of SPY in that window (Column 7).

Comparing Columns 6 and 7 should point out that other one fund, JPMorgan Nasdaq Equity Premium Income (JEPQ), no other large options fund beat the simple passive SPY. What a bummer!

Column 8 compares the Fund’s annualized returns to the SPY’s to show what % of the SPY the fund earned.

Table 1

On average, this small selection of funds mostly underperformed SPY.

(Fund #3) JEPQ earned 112.1% of SPY while (Fund #5) GATEX earned only 49.4% of the SPY.

Why did JEPQ make money? Because the Equity sleeve is the Nasdaq 100 type names. Nasdaq beat the S&P massively since the 2009 bull market started.

However, QYLD did not succeed. Why? Reason #1, while JEPQ sells out-of-the-money calls on the Nasdaq to earn Income, QYLD sells At-the-money calls. In an index going straight up, how we use options matters. Reason #2, QYLD has been around since 2013 while JEPQ is younger. It’s another lesson to wait and slow down. New funds have a timing good luck/bad luck factor.

Take a truer comparison. For JEPQ and QYLD, let’s use QQQ instead of SPY and we get this:

Table 2

JEPQ no longer looks like a star and QYLD looks like a total dud.

In any case, this analysis in incomplete. Looking only at the Total Return does a disservice to the options funds. There are other metrics like the fund’s relative St. Dev to the SPY, Betas, or the Sharpe ratios, the worst drawdowns, etc. Let’s take one of those metrics and stretch our analysis.

Comparison to the S&P 500: Standard deviation matters

Investors’ expectation is not that options funds would earn higher returns. Rather, investors hope the funds will exhibit lower volatility and make the ride smoother. The investors hoped to still earn some of the equity returns with lower volatility than the market.

Table 3

In fact, that’s very much the case. In the above table, calculated using Portfolio Visualized, I’ve highlighted our small group of funds, this time, in Columns 9 and 10, I’ve presented how volatile the fund has been during the window on an annualized basis versus the volatility of the Market. We’ve used % Annualized Standard Deviation as a measure. In Column 11, we show the St. Dev of the fund as a % of the SPY.

We can see that all except (Fund #17) BDJ had a lower standard deviation than the SPY with the triplets of JHEQX/JHQTX/JHQDX (Fund 2, 7, 13) showing the lowest Std. Deviation compared to the SPY.

BUFR (Fund 8) is not far behind.

These funds are common in that these last 5 funds in that table are “Hedged”, “Protected”, or “Buffered” and intend to provide downside protection. The ones above tend to be Income providers and provide no downside protection.

In layman’s terms, this is a vindication of the fund managers’ advertisement pitch and the investor’s hopes: Lower returns accompanied with lower volatility.

Combining the two tables above, I’ve plotted the Return % of these funds and the Std Dev of these funds compared to the SPY. In short, returns between 50-90% with a volatility of 50-90% of the SPY.

Chart 1

Creating a replicating portfolio to push our analysis even further:

Why should we allow options funds an easy pass? In financial markets, there are multiple way to get to the same end point. We now know that options funds have a lower Beta to the S&P 500 (as calculated through Portfolio Visualizer)

Table 4

Let’s take just one fund, JEPIX, which is the Mutual Fund equivalent to JEPI. Together they hold a combined $39 Billion in assets. Using Portfolio Visualizer, I checked the Beta of JEPIX for each calendar year since its inception in Fall of 2018.

Table 5

JEPIX Betas change dramatically from year to year and seem to be on a downward trend recently.

Why does the Beta move so much year to year? It could be the Equity Sleeve and which stocks go in the portfolio. Perhaps the fund managers have a lower volatility portfolio of stocks in 2024 compared to 2013. It could also be the interaction of the options used with the Equity Portfolio and their combined effect.

It doesn’t matter. These funds are constantly changing their underlying characteristics because they are Actively managed. We can’t tell what the Fund manager is thinking. What we CAN DO is tell what the historical Betas have been.

In the case of JEPIX, the story is that this Fund has a lifetime of 0.62 to the S&P 500 Index.

Proposal: Create a Replicating Portfolio

We know that the beta of the S&P 500 (which stands for the market index in the USA) is 1 and we know the Beta of T-Bills is 0. T-Bills have zero beta because these under 1-year Government instruments have nothing to do with the Stock Market. They are short-term obligations of the US Government issued by the Department of Treasury to fund the Government.

We can combine a simple 2 fund portfolio of SPY and T-Bills with the ratio of 61% SPY and 39% BIL (the T-Bill ETF). They won’t have a Beta exactly of 0.62 (in fact, according to Portfolio Visualizer), the 2-fund Replicating Portfolio has a Beta of 0.59 during our Replicating window of Sep 2018 to March 2024. That’s fine. We are shooting for simplicity.

Furthermore, we can choose an option for Annual Rebalancing in portfolio visualizer so the SPY+BIL portfolio rebalances to 62% SPY every calendar year. (If we don’t do that, SPY will keep becoming a bigger % of the portfolio. We want to match the approximate Beta of JEPIX on average over its life).

I ran that simple 2-fund portfolio in Portfolio Visualizer alongside JEPIX. Charts and statistics:

Chart 2

Do you see the difference between the blue line JEPIX and the red line, Replicating portfolio?

NO? Because there isn’t any. The two charts look almost the same. Maybe a little more return in some periods and give back in others, but the differences are minuscule.

Table 6

$100 invested in JEPIX and the 2-fund portfolio would be equal just about the same 5 ¼ years since launch.

For some investors, it might not matter that JEPIX is no better than a simple 62/38 SPY/BIL portfolio. That it’s earned 9% annualized is good enough. My goal is not to get investors to buy or not buy a fund. It is to help simplify and demystify a fund.

Our analysis brings us as close to home as we can expect to be. If we can take all the magic provided by all the financial products and simplify it so we can understand how we can reconstruct that magic ourselves, then we might feel a little more confident in our decision-making process.

Let’s take a case where the results are NOT equal: GATEX

Step 1: Determine a window to calculate Beta. Let’s go with 7 years

Table 7

Step 2: Equivalent Portfolio = 46% SPY 54% T-Bill for period 2018 to 2024 March. Choose Annual Rebalancing in Portfolio Visualizer

Step 3: Output 1: Chart3

Output 2: Metrics: Table 8

GATEX underperforms the Replicating Portfolio by 2.77% per year with a higher Standard Deviation than the Replication.

By all metrics, GATEX cannot beat a passive replicating portfolio. It has a larger max drawdown and a worse Sharpe Ratio.

Let’s take a case where the options fund works well: JPMorgan Hedged Equity Fund (JHEQX).

Step 1: Determine a window to calculate Beta. Let’s go with 7 years

Table 9

Step 2: Equivalent Portfolio = 41% SPY 59% T-Bill for period 2018 to 2024 March. Choose Annual Rebalancing in Portfolio Visualizer

Step 3: Output 1: Chart 4

Output 2: Metrics

Table 10

JHEQX had a higher annualized return of 1.4% over the last 7 years than its Replicating Portfolio, albeit also slightly higher standard deviation.

JHEQX is a good example of an option fund that has so far worked.

Proper evaluation is hard work

We only studied a small number of the over 300 funds dedicated to this space, evaluated an even smaller number, and so we don’t want to make too much out of our analysis.

Evaluation requires some work for each fund. It’s not plug-and-play because the Replication portfolio for each fund needs to first be determined based on the past Beta of the options fund.

We need a history for each fund. We can’t do this analysis for a new fund until we’ve seen its beta versus the S&P.

Since I cannot do this for 300 options funds, (and new funds are starting every day), my goal was to set a framework that others can build on.

Let’s talk about the fund that looks decent: JPMorgan Hedged Equity Fund (JHEQX)

JHEQX is a low-beta fund. At the 0.41 beta, it did a good job outperforming the equivalent SPY and T-Bill portfolio. An interesting follow-up here would be the newer JHQTX and JHQDX, designed in the same vein as JHEQX. As Chart 5 below shows, the Replicating Portfolio’s Orange line beat them both. Maybe the funds need more time? Every time we think options funds might outperform, we peel the onion, and the evidence calls for more time or more analysis.

Chart 5

The Equity Sleeve

Before we conclude, I want to point out that choosing the right Equity Sleeve is very important. A long Nasdaq equity sleeve was so powerful over the last 10-years that it washed away any crimes committed on the options legs.

On the other hand, choosing EM or Developed Market Passive Equity sleeve could have been a terrible choice. No amount of options cleverness would have dissolved the crime of being invested in a passive EM ETF.

Coming to an end: There is a reason why people buy/hold these funds

We took a disparate group of options-based funds and united them. We showed that Total Returns and standard deviation had to be looked at in sync and we accomplished this through the fund’s historical betas, created replicating portfolios, and used the fund’s return series to compare to the replicating portfolios. Our results are important because they are grounded in simplicity, and anyone can replicate the results. Anyone can determine if “their” fund holds water.

While analyzing quantitatively is important, we should remember people buy these funds for at least a few different reasons:

1. Their brokers/advisors sell them the funds
2. Investors are not interested in creating low-beta portfolios and rebalancing
3. Earning income used to be important in a zero-rate world. Options funds had a place. With T-Bills at 5.25%, maybe the options for Income funds need to be rethought. But once invested, the inertia to take money out is great. Investment products are sticky.
4. Tax bills are always a hindrance.

If we visit David Snowball’s thesis, “30% Equity Allocation gets you a majority of the stock market’s returns but skip most of the volatility”, we can appreciate the beauty of low-beta portfolios (the success of JHEQX). Some options Funds promise and deliver the low beta portfolios. Some funds do it better than others (= GATEX) and it’s our job as end investors to pick the good ones and ignore the poor ones.

While options-based funds hold no magic bullets, and a majority of their returns can be replicated by simple SPY+T-Bill portfolios, there will always be a demand for options funds. For as long as investors have been invested in risky assets, they have wanted a smoother ride.

By Charles Lynn Bolin

I wrote Outperforming Actively Managed ETFs last month in the Mutual Fund Observer Newsletter and described Fidelity New Millenium Fund (FMIL) in my “Short List of Great Owl Funds”, but before the newsletter was published, FMIL just up and disappeared! Several members brought it up in the Discussion Board – FMIL Confusion. Fortunately, Charles Boccadoro has solved the mystery by finding “Q&A: Fidelity to Introduce Fundamental Active ETF Suite”.

Fidelity New Millennium ETF (FMIL) has gotten a new name, “Fidelity Fundamental Large Cap Core ETF (FFLC)” under new management with lower fees. FFLC is also transparent which means that you can see what it is invested in daily while FMIL was not. FFLC is part of the new Fidelity Fundamental suite which seeks to “deliver new opportunities and value… while also expanding our investment options to help meet demand for access to equity strategies…”

Upon a little more research, Fidelity rolled out the new “Fundamental” Suite of funds on February 14^th. The purpose of creating this new suite was described by Greg Friedman, Fidelity’s Head of ETF Management and Strategy as, “This launch builds on our legacy of active management through the ETF wrapper, as we continue to leverage both our fundamental approach along with quantitative construction techniques.”

I trust Fidelity to develop new technology and products; however, I am not satisfied with this rollout. I wrote Fidelity Actively Managed New Millennium ETF (FMIL) for the September 2022 MFO newsletter which compared FMIL to its mutual fund counterpart, FMILX. One of the drawbacks as noted by Morningstar is that the FMILX strategy is “contrarian, valuation-conscious approach is distinctive but lacks consistency over time and warrants an Average Process rating…” Okay, there is room for improvement in FMIL.

Change is good – that is good change is good while change for the sake of change is often disruptive. I have changed my investment strategy over my investing lifecycle, some for the good and some not so good. I now invest through Fidelity and Vanguard and use their wealth management services to manage over half of our investments. In particular, I have rationalized taxes as part of my bucket approach. My allocation to stock has increased, and I do less trading and more investing for the long term. This past month, I added to my positions in American Century Avantis All Equity Markets ETF (AVGE) to get closer to my desired allocation. I like the diversification of AVGE.

I had FMIL on my short list of funds that I may want to buy for the long term. As bond ladders mature, I may be looking for an additional fund such as FMIL – Oops! – FFLC to add. What is this new creature?

Fidelity Fundamental Large Cap Core ETF (FFLC)

Fidelity Fundamental Large Cap Core ETF seeks long-term growth of capital. The ETF will normally invest at least 80% of assets in equity securities of companies with large market capitalizations, which for purposes of the fund, are those companies with market capitalizations similar to companies in the Russell 1000 Index or the S&P 500 Index.

Okay, this description is not very helpful. What does Fidelity say about the “Fundamental” suites?

The Fundamental ETFs are designed to provide investors access to Fidelity’s industry leading active management and bottom up research capabilities across the equity investment universe. The investment process applies a quantitative portfolio construction process that seeks to extract and combine the highest conviction investment ideas from multiple Fidelity portfolio managers within a respective asset category, market cap, or style and then optimize the portfolio to ensure style box consistency through a defined risk management process. These investment options not only look to capture Fidelity’s highest conviction ideas within these areas, but also look to deliver strong risk-adjusted returns over the long-term while serving as core equity building blocks.

Again, this description is not informative enough for me to invest my hard-earned money, but it has piqued my interest. Let’s take a look at the Prospectus.

Using an investment process that starts with fundamental analyst research and security recommendations, and reference portfolios managed by Fidelity Management & Research Company LLC (FMR) (the Adviser) that are based on fundamental analysis, and then applying a quantitative portfolio construction process designed to emphasize securities in which the Adviser has high conviction subject to appropriate security and portfolio-level risk, liquidity, and trading characteristics.

 …Prior to February 26, 2024, the fund was named Fidelity ® New Millennium ETF, and the fund operated under certain different investment policies. The fund’s historical performance may not represent its current investment policies.

But I liked FMIL! Will I be disappointed in FFLC or like it better? I compared data from the MFO MultiSearch tool for FMIL that I had saved to FFLC. Even though the fund has changed, the history of FMIL has transferred to FFLC with the update for fund fees and managers. The Fundamental suite also offers growth, value, and small-cap versions, but as someone trying to simplify, I prefer a core approach, but a tilt toward value has potential.

From “Outperforming Actively Managed ETFs”, I used Portfolio Visualizer to create a portfolio of actively managed ETFs to maximize the Sharpe Ratio (volatility adjusted returns) as shown below. To select my next fund, I will consider FFLC among other actively managed ETFs but will take into account that only the information after February 2024 is representative of the new strategy.

So, the mystery of the disappearance of FMIL has been solved. I would have preferred more advance notice of impending changes. Perhaps it was kept quiet as part of a competitive strategy? I will follow its replacement, FFLC, with interest, but as always, a cautious skepticism.

By the way, I did sign up for the Fidelity Newsroom Alerts.