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Covered Call ETFs Sidestep Market Volatility

Many investors have now transitioned to a lower stock allocation during the midst of this early 2016 decline. In fact, it has likely created a new sense of reality that it may be time to transition to a structure of low volatility to wait out the storm. A conventional and highly touted method has been to own stocks with lower historical price fluctuations than their peers like the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). However, there is also another way for ETF investors to own a basket of stocks with built-in options to collect income and potentially reduce price volatility. Covered call ETFs are also often referred to as a “buy-write” options strategy. This process involves owning a group of publicly traded stocks and selling call options on the underlying securities to collect the premium. This can be done by sophisticated investors on individual positions or you can effectively own an ETF or two that will do it for you on a diversified basket of stocks. The end goal is to collect income from the options contracts, which will ultimately reduce the effectiveness of these ETFs during a sustained uptrend in the market. Nevertheless, they have shown far less relative drawdown than their fully loaded index peers during the last two recent corrections. The oldest and most established fund in this group is the PowerShares S&P 500 BuyWrite Portfolio (NYSEARCA: PBP ). This ETF debuted in 2007 and has accumulated $312 million in assets. As you can see on the chart below, PBP has been able to sidestep a great deal of the decline versus the broad-market SPDR S&P 500 ETF (NYSEARCA: SPY ). It was also able to accomplish that same feat in the summer 2015 swoon as well. It’s worth noting that over longer periods of time, the PBP performance story falls short of the stock-only SPY. This is primarily due to the drag of the options buy-write strategy on 3, 5, and 10-year time horizons. In addition, PDP charges a premium expense ratio of 0.75% for the implementation of its unique approach. The income from PBP is interesting because it often experiences big changes over time. Distributions are paid on a quarterly basis to shareholders and over the last 12-months the trailing yield is 5.40%. Some of those distributions have included short and long-term capital gains as well. Another worthy contender in this space is the Recon Capital NASDAQ 100 Covered Call ETF (NASDAQ: QYLD ). This ETF implements a similar strategy based on the NASDAQ-100 Index. The end result is a more concentrated mix of stocks with concentrations in technology and consumer discretionary sectors. This ETF has been able to achieve a similar pattern of reduced draw down relative to the PowerShares QQQ (NASDAQ: QQQ ) during periods of market stress. QYLD charges an expense ratio of 0.60% and income is distributed on a monthly basis to shareholders. This may be a more attractive feature for income investors who are searching for a more regular dividend stream . The trailing 12-month distributions indicate a yield of 10.49% based on the current share price of QYLD. These buy-write strategies have traditionally been a more obscure way to generate income while reducing draw down during sideways or falling markets. This likely means that they are going to be more of a tactical opportunity in the context of a diversified portfolio rather than a dedicated core position. Investors considering these funds should closely research the underlying mechanics of how the income is generated and compare against other potential low volatility alternatives as well. Disclosure: I am/we are long USMV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.

How To Best Gauge Your Risk Tolerance

By Larry Cao, CFA Understanding an investor’s risk tolerance is arguably the single most important issue for an investor and their financial adviser to consider. And yet it never seems to get the attention it deserves. The Definition Risk tolerance refers to your ability and willingness to take on investment risk. Specifically, it indicates how big of a loss you can take in the market without changing course. We are all human and abandon ship when things go wrong. (And that’s why we are not fully invested in equities even when it comes to our long-term investments.) Risk tolerance is the threshold at which you’ll head for the exits. It’s important to measure your risk tolerance accurately. Otherwise all your financial plans are just sand castles and won’t withstand the test of time and market volatility. “I did not really understand my true risk tolerance.” This is one of the painful facts many investors came to appreciate following the global financial crisis. Financial institutions often offer their wealth management clients a risk tolerance questionnaire as a way to gauge their risk appetite and capacity to withstand loss. Investors are typically asked anywhere from a few to multiple sets of questions on their investment horizon, their reaction to different levels of market volatility, and sometimes other factors, such as their education, that regulators or financial institutions may deem relevant. The Issue There are two problems with the current risk tolerance questionnaires and how they are administered. First, is the question of what motivates a financial institution to administer such a questionnaire. Far too often, the questionnaire is the product of internal (compliance) and regulatory considerations. Therefore, the questions may not have been designed to accurately measure your risk tolerance. Second, financial advisers, whether fee- or non-fee-based, are directly rewarded for persuading clients to trade or invest with them. Risk tolerance questionnaires are often treated as a hindrance to profit rather than a tool to gain a client’s trust. I think it’s for these reasons that the single most important question for accurately gauging investor’s risk tolerance often does not get asked. That question is: How often do you check your investment performance? The Solution How frequently you look at a Bloomberg Terminal, check your stock performance on a smartphone, or, in a more old fashioned way, call your broker actually matters quite a bit in understanding your risk tolerance. Run-of-the-mill questionnaires generally give ranges of upside and downside related to investment strategies, in dollar amounts or percentages, and ask which one you’d invest in. The horizon is generally assumed to be a year – that’s how often financial advisers typically meet with clients to discuss financial plans. And yet, what these ranges mean to an investor very much depends on how frequently they check the market. As a service to readers of CFA Institute Financial NewsBrief , we asked them that question. (To avoid ambiguity and guesswork, the question was phrased differently in the poll.) And below are their responses. When did you last check your investment performance? Click to enlarge About 41% of the 558 respondents actually checked their performance within 24 hours (including 7% who checked within the hour?!). Imagine the constant pounding they’ll get in a bear market. In fact, if you are part of this group, just think back to how you felt this January. Experience shows that this group is more likely to overstate their risk tolerance on questionnaires and, hence, are most vulnerable to market volatility when it actually hits. When I was a professional money manager, I belonged to this group. It’s kind of a responsibility that comes with the job. But it is just as hard for professional investors to stomach market turmoil as anyone else. As I recall, in the midst of the financial crisis in 2008, when I asked a portfolio manager from a different firm how morale was in the office, he said, “It is really quiet.” By the way, I am not saying all portfolio managers have to monitor their performance this closely. It depends on how your investment strategy works. For example, value strategies tend to require longer investment horizons, so it’s generally okay if a manager does not check portfolio performance every day. The largest group of our survey respondents (40%) check on their portfolios every month. For most investment strategies and most investors, I think that’s probably the optimum. Still, in terms of gauging one’s risk tolerance, that’s a frequency higher than implied in the risk tolerance questionnaire. So this group suffers from the same problem as those noted above. That adds up to about 80% of investors who are probably overestimating their risk tolerance. How frequently you make your investment decisions has direct impact on your risk tolerance. If you invest you own money, make sure you ask yourself that question. If you are a financial adviser, consider asking your clients that question today. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Why Investors Need Independent Research

Some of the best research in the world comes from Wall Street. It has long been a leader in providing investors with ideas and strategies for investing. At the same time, it is important not to paint all Wall Street research with the same brush. Not all of Wall Street is the same, and some of the research it produces poses certain risks. Risk of Conflicts Of Interest Are Significant The “Chinese” wall exists to ensure that research analysts aren’t influenced by the desire of investment bankers to get deals. That wall is not always as solid as outsiders might think. After the tech bubble, investigations revealed that analysts got paid to help the firm win more IPO business by writing positive reports on stocks they knew were not so good. For instance, one analyst sent an internal e-mail calling a company “such a piece of crap” on the same day his firm published a “Buy” rating on the stock. That company, Excite @ Home, filed for bankruptcy the next year. One might hope that the punishments handed down in the $1.4 billion Global Research Settlement would prevent conflicts of interest affecting research ratings, but that doesn’t seem to be the case. In 2014, the Financial Industry Regulatory Authority (FINRA) fined 10 banks for allowing their analysts to participate in the pitching process for the Toys “R” Us IPO. “I would crawl on broken glass dragging my exposed junk to get this deal,” one analyst wrote to his colleagues . Conflicts Of Interest Are Inevitable It’s understandable why Wall Street analysts would end up getting pressured to help out the investment bankers. After all, equity research is a cost center and does not directly generate any revenue. Revenues come primarily from trading and underwriting, with IPO’s usually offering the biggest paydays. Analysts that don’t help the firm bring in more deals get fired, even if their ratings are accurate. See Fortune’s ” The Price of Being Right “. Plus, the competition for the big paydays from deals heightens the pressure on analysts. In the example above, 10 banks were pitching Toys “R” Us. Every bank knew they had to offer favorable analyst coverage as part of the package, or the retailer would go with one of their competitors. Not surprisingly Wall Street ratings have a significant positive bias. An analysis from Bespoke Investment Group found that, of the 12,122 ratings out there for all stocks in the broad market index, less than 7% were labeled sells, as shown in Figure 1. Figure 1: Wall Street Rarely Issues Sell Ratings Click to enlarge Sources: Bespoke Investment Group Wall Street Is Built On Getting and Giving The Scoop The best way to make money is to be one step ahead of other investors. Sometimes it can be hard to distinguish between “scoop” and inside information. Before Reg FD , Wall Street analysts thrived on passing inside information to their biggest and best clients. That habit is hard to break. It is not surprising that analysts are still trying to find ways to get an edge. As a result, most professional investors know that an analyst’s published research might not always tell the whole story. To get the whole story you have to meet with the analyst in person or attend an “idea dinner”. A recent FINRA fine involved analysts holding “idea dinners” where they offered opinions that sometimes contradicted their published ratings , such as highlighting a “short” call that they’d upgraded to “hold” in public. Sometimes there are reasonable explanations for these contradictions. Maybe new information has changed the analyst’s opinion but they haven’t had the chance to update their report. Maybe the individual investors they’re talking to have a different time frame from the general public. In other cases, analysts might avoid publishing negative research in order to maintain a good relationship with executives . The top investors get word from the analyst to sell, but ordinary investors reading the research reports still see a “Buy” rating. Ultimately, the clients at these “idea dinners” have privileged access because they trade more, and are therefore more valuable to the bank. Consequently, they get a different level of information than those without direct access to analysts. And that’s the real message here. There are a lot of really smart and dedicated analysts on Wall Street, but their interests are not always aligned with the average investor’s. Sometimes, the analyst’s goal to make money for his or her firm overrides the desire to serve the best interests of investors. Most Analysis Behind Ratings Is Not Rigorous The models used by most sell-side analysts tend to rely on accounting earnings or, even worse, non-GAAP earnings . Since CFO’s agree that 20% of companies have misleading earnings , those numbers are not reliable. However, there’s no real incentive for analysts to do the hard work required to reverse accounting loopholes and get to the underlying economics of a business. The lack of conviction behind investment research explains why, for instance, Goldman Sachs has already reversed itself on five of its six big calls for 2016 . Investors that based their strategies around those calls this year are now faced with some difficult decisions. The bottom line is that investors should not be making decisions based solely on Buy and Sell calls from Wall Street. There are plenty of cases where a “Buy” is not really a “Buy”, as highlighted by Integrity Research . Whether it’s to keep the boss or a big client happy, to maintain a relative sector balance, or simply due to being overworked, these ratings can be influenced by many factors besides fundamentals. Independent Research Offers Protection As we state at the beginning of this article, Wall Street provides some of the best research in the world. The connections that many analysts can make with executives sometimes give them unique insight into companies. They can offer valuable commentary on industry trends. There are, however, certain conflicts ingrained with the way Wall Street does business. There is real value in incorporating an independent perspective. Investors deserve research that gets to the core drivers of valuation . They deserve independent due diligence because it is part of fulfilling fiduciary duties and it tends to pay . This diligence helps us to identify stocks that are poised to blow up . As just one example, three months ago, we put Qlik Technologies (NASDAQ: QLIK ) in the Danger Zone. At that time, 21 out of 27 analysts had Buy or Overweight ratings on the stock, and no one had Sell recommendations. Since that date, the stock is down almost 40%. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.