What’s driving increased demand in derivative income ETFs?

As investors look for new ways to diversify their portfolios, derivatives income ETFs are showing strong demand. But what’s driving their surging popularity and why should advisors be considering them for client portfolios?

InvestmentNews has been speaking with Sirion Skulpone, global head of Client Portfolio Management for Quantitative Equity Solutions at Goldman Sachs Asset Management, to find out more about these funds, which include the firm’s Premium Income ETFs, GPIX (S&P 500 linked) and GPIQ (Nasdaq-100 linked).

This type of fund is gaining ground with investors who want equity exposure with lower risk, that potentially outperform the market when returns are more muted and increase income.

“Derivative income ETFs can provide lower volatility exposure to equities, with lower highs and higher lows vs the market,” explained Skulpone. “By writing calls, these strategies sell potential upside in exchange for options premium, leading to underperformance in strong markets, but outperformance in down or flat markets. Additionally, the call premium provides a source of cash flow that may be distributed to shareholders. The combination of lower risk exposure to equities, potential outperformance in down or flat markets, and higher income has become an attractive value proposition to investors in today’s market.”

Skulpone continued that exuberant, double-digit equity markets are typically the environments where call writing strategies will lag the broad market, though they will likely still have positive overall returns.

“We believe that [Goldman’s] Premium Income ETFs can also be used as a complement or alternative to traditional fixed income, as they are a source of income that is not tied to interest rates,” she added. “Additionally, the relatively stable distribution rates may help investors seeking to achieve a specific level of cash flow to meet required minimum distributions within retirement portfolios.”

How do fund managers balance generating income and preserving capital in turbulent equity markets? Skulpone says the team used two primary techniques.

“The first is dynamic options coverage, only selling upside up to the level needed to support the desired monthly distribution. The funds will always leave some of the portfolio fully exposed to the market, generally covering between 25-75% of the portfolio’s upside, depending on market volatility,” she said. “The second technique is strike selection, selling options weekly for diversified strikes. Additionally, we generally sell at-the-money options given they have higher value vs out-of-the money options, again requiring less upside coverage for a given level of premium.”

The way the Goldman Sachs Asset Management funds are managed is also designed to have tax advantages.

“We have historically distributed the majority of the distribution as Return of Capital, which is not taxable to the shareholder in the year of distribution and instead reduces the cost basis of the ETF shares and the shareholder will be taxed when shares are sold,” Skulpone said.