Should I Invest in the 16.88% Yielding Simplify Volatility Premium ETF (SVOL)?

I spent the weekend gathering some thoughts about investing. I have some funds aside from Daedalus that I might want to increase the allocation to higher risk.

One of the funds that I am thinking about is SVOL. SVOL is the ticker for the Simplify Volatility Premium ETF. This is an actively managed ETF that is incorporated in the US, so it is not the most estate tax-efficient security out there.

When many securities fall in price, your ideas can come from many areas. I think the sensible thing sometimes is not to get distracted and just add to your main investment vehicle. This can be VWRA, IMID, CSPX, you name it.

However, this might be a great opportunity to start a position in an idea that you might think is not a good price to buy last time.

The VIX or the CBOE index which expresses the implied volatility of the S&P 500 index finally is able to be “freed” to rise nearly to 30:

We finally moved from a very low volatility regime (below 16) to a much higher regime. Equity investors may need to get adjusted to greater price movements rather than such a long period where the S&P 500 does not have any greater than 2% price correction.

That got me curious about SVOL.

This is the kind of environment that a strategy like SVOL will go to shit if it is not implemented and executed well.

In the chart below, I plotted the price movement of SVOL (top candlestick chart) against the price change in the VIX (orange chart):

There is a perfect inverse price relationship between SVOL and VIX, in the last two days, SVOL dropped 4.5% when the VIX climbed almost 43% in the same period.

This is the kind of environment that are headwinds for SVOL.

What’s the Big Deal Over SVOL?

The price chart that we see above is only the price movement.

Here is a glimpse of the past dividend distribution of SVOL:

The first observation is that SVOL distributes dividends every month.

For the past few months, the dividends are consistently US$0.30 monthly. If we add them up it is about $3.60782.

Now, let us take SVOL’s price before this plunge of about $22.78.

The dividend yield is 15.8%.

That might have perk some of you up.

“If I put $1 million into this, I am going to get a monthly income of $13,000!”

But hold up… why is the prices drifting down?

Perhaps a better way to assess performance is to look at the total return. In almost all things, it is better not to only look at the dividend yield but the capital returns with dividend yield.

The table above shows the cumulative returns (top) and annualized return (bottom). SVOL was incepted in the mid of 2021, so unfortunately we are unable to see how it performs in the crazy month of Feb-Mar 2020.

The return here is net of expense ratios and what you would earn from the start, as you see the NAV of the fund drift lower.

The falling NAV and the high yield may make you more cautious and uncertain about what kind of returns an investor would expect going forward. Is the NAV going to zero? Is return sustainable at all?

The Fundamental Basis of SVOL

At Providend, how we look at each investments that come across our table, be it by the boss, or a client and decide whether we should add to any of our portfolios is our Investment Philosophy. Our Investment Philosophy is made up of 4 pillars and the first one is Economic Basis.

If you had asked me, we should have changed that pillar to just Basis, and it would have been simpler.

SVOL is an actively managed strategy based around holding bonds, futures and options. We can group what the fund holds to the following:

1. 20-30% of the portfolio: Sell or short VIX futures contracts.
2. The majority of the portfolio: Invest in T-bills, Notes, TIPS or Fixed Income ETFs.
   • Fund may potentially sell fixed income options to enhance income.
   • Or to acquire the fixed income at more attractive prices.
3. A small allocation to out-of-the-money VIX call options or equity put options.

There is a fundamental basis for using derivatives such as futures and options. Different group of people use options and futures to hedge for their businesses if they need to lock in fixed revenue and costs for stuff that will be volatile. These can be the prices of agricultural produce or to fix prices of equity securities if a large sale and purchase takes place later.

These derivatives are not without risks, and if you benefit, someone on the other end might be at the short end of it. Having risks means that there is some sanity to its return because with almost all things, there is a return at the end of the rainbow because there is some sort of uncertainty.

The main bulk of SVOL’s return comes from shorting the VIX futures contracts to earn something call a Roll-yield.

The illustration below shows a typical VIX Term Structure:

The x-axis shows a few VIX futures contracts that are lined up from how far they will mature with VIX Fut6 further from maturity. The y-axis shows the price of the VIX futures.

We notice that the price of the VIX futures that is closer to today (to the left) is lower than the VIX futures further away. But why is that? I look at the VIX futures as a form of insurance premium. People buy the VIX to protect against potential large downside volatility to the S&P 500. The further away you are from today, the greater the uncertainty, and so the price of the future is higher.

SVOL will sell a VIX futures that is further away. As time passes, the price of VIX should head down, as the curve, and the manager will buy back the VIX futures at a lower price.

The SVOL investors profit from the spread between the price it was sold and how much it is bought back at.

A curve that is lower nearer today and higher further from today is said to be in Contango. However, this is not always the case.

A nearer-term VIX futures contract can be more expensive or as expensive than those that are further away. When does that happen?

There are periods of uncertainty in the markets where investors places greater demand on VIX protection that is nearer to today.

An opposite sloping curve (where the nearer is more pricey than the further) is called Backwardation.

For equity investors: A review of the VIX futures, whether they are sloping which way or the pricing of the futures, can give a probability guess of the degree of “fear” or what investors are thinking regarding how long the fear will last.

If you kind of understand this, you would understand that this short sell of VIX futures is not without risk for if the VIX jumps in the shorter tenor, you will buy back more expensive, losing you money. There is risk here and therefore there is a basis of how returns come about.

In order to short sell the VIX futures, the portfolio need collateral and that is the role of the fixed income on the portfolio. Predominantly, the fixed income is made up of Treasury bills but they have the flexibility of using other fixed income options if that presents a better opportunity.

Lastly, the portfolio spends a small amount of its budget on out-of-the-money equity puts or VIX calls for protection. We will cover more of this later.

What You are Paying the Expense Ratio For?

If you look at what the fund holds, you can see what you are paying the manager to do:

1. Harvest the VIX roll yield by selling VIX futures. There are times when the better risk versus reward is to sell closer to today, and there are times when it is better to sell further.
2. To invest in the income-producing assets and, at times, write/sell options against the assets when the opportunity presents itself.
3. Execute strategies to prevent tail risk from killing your portfolio.

You might have the same idea as Simplify, the company managing the ETF, or you might not, but you are asking them to execute the strategy on your behalf when you buy such an ETF.

What Drives the Returns of the ETF?

Simplify provide the following decision tree to help us visualize under what conditions will the ETF perform well and when it will not:

I think more advisers or financial product providers should do this. I wonder does it makes sense to keep coddling your clients or prospects by underplaying the risks of investments until they blow up in all our faces. The first thing you have to acknowledge is that if you want high returns, you would either have to be open to the prospect of either large drawdowns, significant volatility, or a high fee for the effort put into risk management.

If we are in a Contango term structure and the VIX curve is steep, it allows the fund to earn a fatter roll-yield. If the curve is flat or in Backwardation that is where the strategy suffers (somewhat like now).

Tail Risk Management

Given the fat yield, what is the risk here?

If you have written or sold naked put options on indexes or stocks to earn income before, you would know that the strategy is like picking pennies on a railway track. You are likely to earn and then get steamrolled one day.

In Feb 2018, two VIX call-writing ETPs were steamrolled during what is now known as “Volmageddon”.

One of those products is the VelocityShares Daily Inverse VIX Short-Term note (ticker: XIV). In one session, XIV shrank from $1.9 billion in assets to $63 million.

Investors gravitate to funds like XIV because of their greed for yield.

A combination of factors popped the VIX to what you see in the screenshot above. Imagine if you have no just one XIV but a few funds operating strategies of similar vein trying to buy back their futures to limit their losses.

That buying of the VIX fxxk things up even more creating a Game Stop short squeeze effect.

The losses wiped off the whole value of the fund.

Would SVOL be subject to the same risk?

Well, that is the role of the put option buying or VIX call option. The portfolio spend some of its budget by buying this “portfolio insurance” consistently at a strike price of 50. This means that if the VIX spikes near or greater than that, and the options print, then the portfolio manager can sell the VIX call to monetize and limit the losses.

Aside from that, SVOL have only a 20-30% exposure to these VIX futures sell. This means that the fund is less exposed. I feel that the challenge is to successfully monetize the VIX calls in such an event.

“Volmageddon” is so talked about that lead me to believe if you were to structure some sort of VIX covered call-like strategy, you would address such an event.

The Challenge is in the Execution

One of the main reasons we decide not to add a lot of funds to the portfolio is because a lot of things doesn’t satisfy the Implementation pillar of our strategy.

Usually, these strategies can be costly but if they are not, we question whether the active manager can execute consistently.

All these strategy looks good on a slide deck, the big question is whether they can implement and execute what they said out to do well, and over a long period of time.

The team have been managing pretty well the past three years in a market where derivatives are affecting markets more and more.

But aside from implementation, I always wonder if there are the “unknown knowns” or the stuff others know about that the manager don’t know about that would surprise and kill the fund. The team at Simplify based their business on structuring products around options and I would like to think they are sophisticated in this area.

I guess there is risk in all strategies. We could argue that despite how much I know about equities, we cannot rule out things becoming bad dramatically in a way that we struggle to imagine.

This brings us to how this would fit into your portfolio.

The Role of SVol in a Portfolio

The returns from our portfolio will come from the risk we take and so our portfolio should be made up of different forms of risk that we are compensated for.

SVOL is unique in that it allows us to harvest a different sort of risk premiums that may be less correlated with the equity and fixed income. While the tailwinds that will benefit SVOL is an environment that is good for equities, there are situations where SVOL will do well when equities in general do not do well.

This makes SVOL a good diversified.

Simplify recommends that if we were to add SVOL, we should replace some of our equities allocation with SVOL instead of the fixed income allocation.

The product is touted to have a lower volatility than a portfolio of diversified equities.

While the product do produce a good dividend return, I think the way to see SVOL is to view its income return to be part of the total return of the fund, as part of a portfolio based around an accumulation strategy.

Conclusion

SVOL is an interesting product to study more from an educational perspective. I would add SVOL to my less important portfolio because of the implementation concerns and it’s short operating history.

Simplify produced what I think is a pretty comprehensive video that explains the long and short of their product:

I share this with you not because I recommend it but more because I want to take this opportunity to better understand a derivative-based, actively managed ETF. If there are parts of this post that you struggle to understand such as roll-yield, contango, backwardation, selling and buying out-of-the-money options, this means that this product might not be so suitable for you.

If I think about what makes an income stream more robust, it is one where what drives the income is not just fixed income or equities but through other risk factors.

Harvesting the premiums from other risks seems to fit the bill.

I will probably report back on how the dividend withholding tax is also treated.

If you are interested in high yielding products like SVOL, you might be interested in my deep dive on the 12% yielding QYLD and similar covered call writing ETFs.

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