In a world where uncertainty is a certainty, predictability is increasingly at a premium for investors. As a result, many are turning to defensive investment tools and products to balance risk and reward.
US equity markets performed well in 2023 and 2024. Factors such as decelerating inflation, resilience in jobs, the influence of the Magnificent Seven, and an AI boom all supported a continued bull run. However, a more recent combination of sticky inflation, diverging interest rate policies, and geopolitical tensions have forced investors to seek solutions which allows them to benefit from the strong names that are still performing well in the stock market, with the ability to secure a steady income stream. Income-seeking investors could therefore adjust their equity portfolios and look for ways to navigate volatility.
One such adjustment could be options strategies, which can help investors navigate a variety of market conditions, generate income or manage risk. Often, these strategies can invest in specific assets, such as the stocks in an index, and buying or selling calls and put options on those same stocks to attempt to achieve the desired outcome. As such, Defined Outcome ETFs can be an efficient tool for investors looking to incorporate alternative risk premia or reduce market beta in their portfolio.
Accessing the options market
Thanks to the customisable nature of Defined Outcome ETFs, investors can build and design portfolios reflecting their unique needs, focusing on expected outcomes rather than historical returns – while having full transparency on the terms of engagement such as the buffer percentage, cap, and duration.
The “buffer” element means that these ETFs are designed to offer some downside protection in exchange for an upper cap on total returns. In other words, investors give up some potential gain for the comfort of knowing that a portion of losses may be limited. During a period of market volatility, this partial protection against market losses may be more valuable to investors than the potential upside gains, thereby driving demand for Defined Outcome ETFs in anticipation of higher volatility.
Diversification
Diversification has long been a tool that investors have used to navigate market volatility. Covered call strategies put this to the test by diversifying the source of risk in a portfolio. Rather than portfolio calls being written on single company securities, such strategies can also be implemented on diversified stock indices.
Covered Call strategies provide additional diversification by helping to monetise volatility via monthly call option writing. Investors may incorporate covered call strategies into portfolios as a core holding to replace a portion of US equity exposure, as the options premiums generated from selling calls can smooth drawdowns, or an additional alternative source of income, in times of heightened volatility.
In fact, covered calls are best placed to perform well in flat and or slowly rising markets. While strong performances in bull markets can lead to covered call strategies forfeiting the upside of index exposure. However, in a flat market, these strategies benefit from premiums received from selling call options while there is no lost opportunity cost of the underlying index exposure rising. When stock prices in a strategy fall during a bear market, a covered call strategy may also outperform due to the premiums collected from selling call option writing, which may offset some or all of the underlying market’s decline.
A particular example of covered call strategies garnering greater interest are those where one can participate in US Equity market indices whilst simultaneously generating portfolio income via writing monthly European call options on the underlying indices. Such strategies tend to outperform in more volatile markets because of the higher income generated from option premiums which monetise market volatility. Simply put, volatility increases option premia.
Covered call strategies can offer income certainty and consistency by paying either monthly or quarterly distributions. As interest rates remain elevated and equity market returns become less predictable, investors may find comfort in the steady monthly income stream. While they sacrifice some upside, a stable income profile can be an attractive enough trade-off.
The best of both worlds?
As market volatility continues, the demand from investors to balance the upside and downside is likely to continue. What unites these ETFs is the ability that investors have to tailor portfolios to achieve income goals and satisfy their risk tolerances.
In a variable market environment, capping gains can be a worthwhile price to pay for risk reduction. This increasingly acceptable trade-off reflects a more pragmatic investment philosophy. As traditional returns may struggle to compete in this market, option-based ETF strategies can serve as strategic complements, or even be designed to be the right alternatives.
Having the best of both worlds is never an easy task, but investors are increasingly recognising that these tailored ETF strategies may help to generate income, manage risk, or both.
Alexander Roll is Investment Strategist at Global X ETF Europe. The wider firm is based in New York, but Global X Europe is headquartered in London.
