HIGH ETF: Unique Income ETF Focusing On Option Spreads, 9.4% Distribution Yield

The Simplify Enhanced Income ETF (NYSEARCA:HIGH) is a somewhat unique income ETF, investing in t-bills and equity options spreads. The strategy aims to generate significant income with low credit and rate risk / exposure. It seems to have succeeded, with the fund sporting a 9.4% distribution yield with low volatility and drawdowns. I rate the fund a buy, but the fund does have some risks, and performance is somewhat dependent on management execution. Significant, overweight positions in the fund seem unwise, as is using it as an alternative to cash.

HIGH – Holdings and Strategy

HIGH invests most of its portfolio in simple t-bills. In most cases these investments do not yield a significant amount, but right now they do, and are an important source of income and returns for the fund.

HIGH also invests in equity option spreads. Although their market values tend to be tiny, they have an outsized impact on fund performance and income. Specifics vary, but most option spreads are structured so as to generate a modest amount of monthly income at low risk. In theory, at least. Looking at a specific option spread might prove instructive. From the fund’s latest semi-annual report, relevant position highlighted:

In the example above, HIGH sold a put option on the S&P 500 index. Said option gives HIGH’s counterparty the right, but not the obligation, to sell &P 500 shares for $3,650 at 1/13/2023 to HIGH (indexes do not technically have shares, but let’s assume they do in the example). In other words, HIGH might be obligated to buy S&P 500 shares at said price and date.

HIGH’s counterparty would only exercise said option if doing so were profitable, which occurs when the strike price is higher than the market price. As an example, if the S&P 500 were to plummet to $1,000 per share, HIGH’s counterparty would buy shares at $1,000, and force HIGH to buy at $3,650, netting $2,650 in profits per share. HIGH would suffer losses of $2,650 per share in this scenario, as it would be buying shares valued at $1,000 for $3,650.

In exchange for (potential) losses and risk, HIGH receives a hefty premium from the counterparty. Figures vary, but the fund seems to aim for 4.0% – 5.0% per year, on net.

An issue with selling put options is that significant declines in price might lead to significant losses. Although this might not be a concern for many investors and funds, HIGH aims for attractive risk-adjusted returns, and no tail risk. To remedy these issues, the fund focuses on short-term options which are out-of-the-money. At the same time, the fund bought another put option, this one with a lower strike price.

Said position allows the fund to (potentially) unload unwanted S&P 500 shares at a reasonable price, eliminating the possibility of significant, outsized losses.

As an example, let’s assume that the S&P 500 drops to $1,000 per share. HIGH would be forced into buying at $3,650 per share, due to the put option they sold. HIGH would then sell these shares at $3,250 per share, due to the put option they bought. Losses would equal $400 per share. Losses would be high, but much lower than the $2,650 if they hadn’t bought the put.

In exchange for (potential) reductions in losses, the fund must pay a premium to buy the put option above.

As mentioned previously, the specific equity option spreads used vary, but the overall aims are the same. Options are bought and sold so as to generate strong premiums and income. Options are selected so as to reduce potential losses. Options are selected so as to generate attractive risk-adjusted returns. In theory, at least.

In practice, the fund’s strategy does seem to work.

Dividends are attractive, with the fund sporting a 9.4% dividend yield.

Dividends seem to be mostly covered by underlying generation of income and premiums, as evidenced by mostly stable share prices and NAVs since inception. Both are marginally down, however, as there seems to have been a small amount of ROC / asset erosion these past few months.

Considering fund dividends, expenses, t-bill rates, and share price declines, the fund seems to generate around 3.0% – 4.0% in option premiums every year. Lots of volatility in these figures, however.

Risks are quite low too, as the fund has little in credit or interest rate risk. Drawdowns and volatility are both extremely low as well, and much lower than most asset classes, including equities, bonds, and treasuries. Some of the volatility is due to normal intra-day ETF volatility too. T-bills are much more stable, however.

Risk-adjusted returns seem quite strong as well, considering the fund’s high dividends and returns, and low risk and volatility. Share ratios are higher than t-bills, bonds and equities, although the fund has only existed during a time of heightened market volatility, so these figures might not necessarily last for long.

HIGH offers investors strong dividends, returns, and risk-adjusted returns, with low risk and volatility. It is a solid combination and makes the fund a buy.

I am concerned about two issues.

First, option spreads are not necessarily profitable, low-risk trades with strong risk-adjusted returns. HIGH seeks option spreads with these characteristics, but the fund might fail at said task, and the market might also fail to generate such opportunities. Performance is moderately dependent on management capabilities and execution, an important risk.

In my opinion, said risk is unlikely to result in significant losses, but could result in slight underperformance, as was the case in November.

As an aside, it should be possible to calculate max possible losses from the fund’s options spreads. As per my calculations, and that of other authors, these tend to be between high single-digits and low double-digits.

Second issue with the fund is related to the distribution of gains and losses. In my opinion, based on the fund’s strategy and holdings, HIGH should generally generate a good amount of income and returns, but sporadically suffer small, but noticeable, losses. Although these might not make a significant dent on an investor’s capital, they might wipe out a couple months’ worth of distributions, perhaps a year or two. This is an important risk, and one which is easy to ignore.

Conclusion

HIGH is a somewhat unique income ETF, investing in t-bills and equity options spreads. The fund offers investors a strong 9.4% distribution yield, with low volatility and drawdowns. I rate the fund a buy, but as performance is somewhat dependent on management execution, significant overweight position sizes seem unwise.