As discussed in the last article, ETFs inherit many of the pricing attributes of a derivative, on top of their value as mutual funds. This means that the value of these assets comes indirectly from the underlying assets of the security itself, as well as the market’s perception of how it is that these underlying assets will perform in unison.
This last point is important to us as investors, because it means that we need to look at ETFs as being marginally differentiated from their holdings. From here, we can begin to see that there is opportunity to exploit these marginal discrepancies in a way that adds stability to a somewhat volatile position.
The two main benefits of purchasing an ETF stem from economies of scale that provide investors with access to affordable yield. As personal investors, this yield should be extremely attractive to us, because it allows us to plan our lives around predictable incomes.
However, because of the way in which an ETF might be more thinly traded than the underlying securities themselves, we can see that there will sometimes be a great deal more volatility in the ETF than in the underlying assets themselves, even though they will generally move together in accordance to Net Asset Value (NAV). While this sort of volatility is ok over the long run, it certainly is enough to make a person nervous about their holdings. However, we have access to some simple strategies that an investor can use to help stabilize these overall returns.
One way to stabilize the returns from an ETF is to hedge out the capital gains of the position by interacting with the underlying securities directly, even while holding the fund. For example, if a technology fund is over-exposed to a single position, but has many other appealing opportunities, investors could simply short-sell a balancing position in their portfolio directly, and hold a proportionate amount of the fund for the yield.
Alternatively, if an investor wanted access to only the high yield of a covered-cap fund, without the volatility of the equities themselves, they could simply balance out the entire portfolio in exchange for a few percentage points of yield, and reap the benefits of the professional derivatives management. This last strategy is a fantastic way to pursue covered call income without having to take the time to manage the positions every month on your own.
While personal investors certainly do have options available to them to pursue these kinds of specific strategies, it is important to remember two key concepts surrounding them. Firstly, these kinds of strategies require some careful planning calculations, so as to not over-expose a portfolio to an offsetting position. Secondly, it is important to remember that the correlation between the two assets can sometimes change, meaning that a portfolio will need to be rebalanced to reflect the change in valuation. From a practical perspective, this means that we should always consult with a financial advisor that has experience in planning these sorts of strategies, so that we can make sure that we’re not taking on any undue risk because of a lack of experience.
