We’ve talked earlier than about how exchange-traded funds (ETFs) symbolize an environment friendly software for gaining fast entry to several types of belongings or funding exposures. We’ve additionally mentioned how choices have grow to be more and more well-liked lately.
As we speak, we mix each subjects and take a look at ETFs that embrace choices. We see that it’s a rising section of the ETF panorama.
ETFs with choices give totally different returns to a inventory portfolio
Choices work slightly in another way than equities. Choices expire — generally within the cash, generally not — making their returns not “linear.” As well as, choices will be:
- Held individually (single leg).
- Mixed with different choices (multi-leg).
- Mixed with underlying fairness exposures (overlay).
This can be utilized to create portfolios with totally different payoffs, like further revenue or draw back safety.
ETFs with choices have been rising
As the info under exhibits, belongings into choice overlay ETFs have elevated considerably since 2020, when markets skilled a pointy sell-off across the COVID-19 pandemic.
Previous to 2020, combination belongings underneath administration (AUM) on this class was round $5 billion. As we speak, those self same varieties of methods symbolize over $160 billion, with the majority of belongings invested in both enhanced revenue or hedging methods (extra on the variations later).
Chart 1: Belongings in choice overlay ETFs
In truth, once we take a look at annual ETF launches, we see that choice overlay funds have typically represented between 20% to 30% of recent fairness ETF launches since 2019 (Chart 2).
Chart 2: Possibility overlay ETF launches
What choice overlays are the preferred?
Not all choice overlay methods are the identical. Choices will be mixed collectively in a portfolio to focus on a pre-defined end result. In Chart 3, we group funds in line with Nasdaq’s in-house fund taxonomy:
- Enhanced Earnings Methods (Inexperienced) primarily attempt to enhance revenue. That is sometimes executed by writing, or promoting, choices to obtain premium revenue along with lengthy fairness publicity (e.g., coated name like QYLD or put-write like WTPI).
- Hedging Methods (Orange) primarily intention to guard draw back whereas offering some upside participation through lengthy put choices, and brief name choices (e.g., conventional buffer funds like PDEC and FNOV, or 100% draw back safety funds like TJUL).
- Enhanced Efficiency (Blue) attempt to outperform a benchmark by means of elevated revenue (e.g., OVL, or SPYC).
As of March 2025, we tallied over 430 fairness ETFs with choices, representing over $160 billion in complete AUM. Nonetheless, as we are able to see under, the revenue and hedging methods symbolize nearly the entire complete belongings within the house.
Chart 3: Possibility overlay ETFs by strategic focus
How do they work?
Every overlay technique is usually some mixture of lengthy and brief positions in name and put choices, all producing barely totally different outcomes. The diagrams under present how the mixture of inventory publicity (diagonal line) and choices exposures (“hockey sticks”) mix an indicative portfolio return profile that’s “not linear” (the blue line just isn’t straight).
Chart 4: Hypothetical payoffs of several types of choice overlays
The diagrams above present how among the well-liked overlay methods work. Notice that there’s often a trade-off to supply these returns. The blue line is typically above the diagonal inventory returns (higher), and generally under it (worse).
The advantages of every are additionally totally different:
- Coated name – generate revenue with restricted upside.
- Protecting put – absolutely defend draw back however take part in upside.
- Conventional buffer fund – buffer draw back (as much as a sure level) and produce some upside fairness participation.
- 100% draw back safety (or collars) – just like conventional buffer funds, besides draw back is absolutely protected.
A deeper dive into coated calls and protecting places
The first option-overlay ETF within the U.S. market was the Invesco S&P 500 Purchase/Write ETF (PBP), which implements a coated name technique on the S&P 500.
A coated name sometimes has two positions:
- Lengthy fairness publicity – merely put, the worth of the place goes up or down 1-to-1 with the underlying inventory worth.
- Brief name choice – assuming the place is held to expiration, if the inventory worth is lower than the strike worth, the place retains premium. In any other case, the place loses worth.
The premium earned from promoting the decision helps the mixed portfolio beat a easy inventory fund, despite the fact that the mixed publicity (blue line) nonetheless falls as inventory costs fall. Nonetheless, as soon as the brief name is “within the cash,” train payouts of the choice are offset (coated) by positive factors on the inventory. The upside is capped by the brief name strike.
A protecting put however works like insurance coverage in opposition to the inventory portfolio falling (under the strike worth). The mixed portfolio nonetheless gives publicity to upside, however the price of the choice (premium) reduces the return in comparison with a easy inventory place (the blue line falls under the lengthy inventory line).
Chart 5: Lengthy fairness + single choice
General, there are about 70 varieties of U.S. funds implementing coated call-like methods with almost $90 billion in complete belongings underneath administration (AUM).
A deeper dive into buffer methods
Buffer methods are usually barely extra advanced with a number of layers of choices. Buffer methods intention to offer draw back safety and a few upside seize.
There are sometimes 4 main parts of a standard buffer technique, and Chart 6 under illustrates every of the steps sequentially (notice that the darkish blue line represents the online payoff profile for every stage):
1. Set up Fairness Publicity – both by going lengthy the index or shopping for a deep in-the-money name choice.
2. Set the “Cap” – by promoting an out-of-the-money name choice. This establishes the “cap,” or the restrict to how a lot upside return the technique can obtain.
Set the buffer vary by:
3. Lengthy Put Possibility – establishes the beginning of the buffer.
4. Brief Put Possibility – establishes the tip of the buffer and in addition partially funds the draw back buffer.
Chart 6: Tips on how to create a buffer
General, Step 4 in Chart 6 highlights the anticipated payoff when combining all parts. Although, we should always notice that the realized payoff could deviate from the anticipated payoff proven above relying on different components, similar to when an investor buys or sells the technique relative to the beginning and finish of the outlined end result interval.
The most important trade-off is the upside potential vs. draw back safety. The buffer technique can solely earn a return as much as the cap, so if the reference asset exceeds the cap, the buffer technique will underperform.
Regardless of the potential underperformance in “up” markets, traders should be drawn to buffer methods as a consequence of their capacity to restrict draw back at a decrease price than merely “shopping for a put,” due to promoting of different choices within the mixture to earn again some premium.
Notice that, typically, buffer methods have traditionally outperformed underlying benchmarks during times of market stress. For instance, Chart 7 under highlights the rolling drawdown of a group of buffer methods from 2020 to the current, relative to the Nasdaq-100® (NDX®) and S&P 500. It exhibits that the gray space falls lower than a easy inventory portfolio (dots).
Chart 7: Rolling drawdown of buffer funds
Who’s managing these ETFs?
Curiously, nearly all of belongings are managed by only some ETF issuers (Chart 8):
- J.P. Morgan is the most important issuer, with round $65 billion in belongings and the 2 largest ETFs (JEPQ and JEPI).
- They’re adopted by First Belief and Innovator ETFs, each of which focus way more on draw back protected (orange) methods.
- Though International X, Amplify and Neos have fewer ETFs, their suites embrace among the hottest ETFs with choices (QYLD, XYLD, DIVO and SPYI).
Chart 8: High ETF issuers of choice overlays
Why this issues
Possibility methods will be tailor-made to fulfill several types of outlined outcomes. ETFs with choices make it straightforward for traders to entry a few of these extra difficult methods.
Nonetheless, as a result of a majority of these methods are advanced, they might not be for everybody. As at all times, it’s essential for traders to know what they’re shopping for to keep away from any undesired outcomes.
General, choice overlay methods symbolize simply one other instance of how developed the U.S. markets have grow to be.
