RYLD: Optically Enticing, But Fundamentally Still Weak (NYSEARCA:RYLD)

In September 2023, I circulated an article on the Global X Russell 2000 Covered Call ETF (NYSEARCA:RYLD), which applies a covered call strategy against Russell 2000 Index by going long Vanguard Russell 2000 ETF (VTWO) and writing covered calls against the index – VTWO.

The thesis was simple and bearish, as the underlying exposure to small-cap names introduced a notable opportunity cost that is associated with not having any allocation in place against growth-tilted factors, which have been consistently outperforming the value universe. On top of this, the implied volatility of VTWO or Russell 2000 was just too low to provide a meaningful advantage over similar covered call ETFs, but that focus on growth-biased indices such as Nasdaq 100 (e.g., the Global X NASDAQ 100 Covered Call ETF (NASDAQ:QYLD)).

Moreover, if we zoom back and take a look at the historical 5-year total return performance by RYLD and contrast it with QYLD, we will notice that RYLD tends to structurally underperform the QYLD.

All of these aforementioned aspects substantiated my bearish stance on RYLD, which since the publication of my article has played out nicely (i.e., RYLD underperforming the S&P 500 and QYLD by ~15% and ~8%, respectively).

However, given the recent moves in the technology stock space and the struggling S&P 500, the Russell 2000 index has become a more attractive alternative. In this respect, when there is an increased chatter and enhanced prospects for rotation from growth to value (driven by the strengthening of higher for longer scenario), RYLD optically seems also a more enticing investment choice. The embedded covered call strategy helps as well as the risks of recession and / or stagflation are rising, which, in turn, should put an upward pressure on the market volatility levels.

With this in mind, let me now review my previous thesis on RYLD to see whether there is a justified basis for upgrading the ETF to buy.

Thesis review

What is immediately worth noticing is the fact that over the past 3 months, RYLD has finally outperformed its peer QYLD, which follows a similar strategy but with a focus on the Nasdaq 100 constituents rather than smaller cap names that are embedded in the Russell 2000 universe.

The reason for this is as what I described above in the article – i.e., since the market begun to recalibrate the path of interest rate cuts to a more conservative scenario, the growth biased stocks have suffered, delivering worse results than most of the value names. For RYLD this has come in handy as the ETF has been able to register upside as far as the written option strikes allow.

Another important driver has been the increase in the volatility that has benefited the short volatility strategies across the board (including the covered call strategy that is assumed by RYLD). As the chart below shows, the VIX has increased from the early 2024 levels.

So, the combination of increased market volatility and well-performing Russell 2000 stocks have provided a nice tailwind for RYLD to deliver acceptable results, even outperforming QYLD.

With that being said, there are two important caveats that the investors have to take into account.

First is the divergent dynamics between the VIX (measuring the vol of the S&P 500) and RVX, which captures the volatility space of the Russell 2000 companies. While the RVX level has indeed gone up since the start of this year, the increase has not been material and already now it shows clear signs of convergence back to stable levels. This means that one of the major drivers of RYLD performance is not there to provide notable support for the yield generation going forward. Plus, the fact that the VIX is higher (on a relative basis) implies that the covered call ETFs, which focus more on the tech related stocks, are better positioned for collecting attractive option premiums.

The second caveat is related to the negative alpha of RYLD compared to the VTWO total return performance. The chart below captures the essence nicely.

In other words, it shows how poor RYLD is in participating in the gains of the underlying index it tracks (or sells calls against). The difference is so large because on the one hand the underlying index – VTWO – has spiked higher in a notable fashion, which is bad scenario for any covered call ETFs as the strikes of the sold options typically are not that far from the index value when the selling process takes place. On the other hand, the implied volatility of Russell 2000 has not surged in a similar way as the index price, which also imposes a headwind for RYLD.

The bottom line

While on the surface it might seem that the prospects and fundamental investment strategy of RYLD have become more attractive, the reality, if we assess the situation a bit deeper, is different.

Theoretically, the increased dynamics of flight to quality coupled with rising volatility levels should create favorable conditions for RYLD to deliver strong results going forward. However, the rate of change of RVX has not been that strong to compensate the surge in VTWO, and as of now it indicates signs of compression, which should impose further headwinds for RYLD. The only scenario under which RYLD could register fairly enticing results is when VTWO remains stable or goes up or down in a very gradual level, while the larger growth company related indices exhibit also range-bound dynamics so that there would not be a notable opportunity cost for RYLD investors. In my opinion, this is a low probability scenario given the macro-level uncertainties stemming from interest rate uncertainty, increased distress in the office space, geopolitics and stagflation risks.

Given all of this, I still consider the Global X Russell 2000 Covered Call ETF a subpar investment choice that is associated with a notable opportunity cost.