When it comes to exchange-traded funds, Wall Street is very good at figuring out what investors want and then giving it to them, whether it's good for them or not. Often, that means ETFs come out at exactly the worst time for fund buyers, as a hot sector tops out just after ETF shares become available.
But one new ETF from AdvisorShares actually comes at a reasonably good time for conservative investors. With stocks at five-year highs and soaring in the wake of coordinated central-bank intervention to stimulate the global economy, this new ETF uses a strategy that gives fund shareholders a chance to express their caution about the future direction of the stock market.
Hedging your bets
The name of the new AdvisorShares fund is STAR Global Buy-Write ETF, and as Barron's reported yesterday, the fund will be available to new investors early next week. The ETF plans to use what's known as the covered call strategy, which uses a combination of stock and options to create a hybrid investing model that's somewhat more conservative than simply owning stocks outright.
The covered call strategy works like this: First, the ETF buys shares of stock. Rather than stopping there, though, the ETF then turns around and writes a call option on the stock it bought, typically giving the option buyer the right to buy the stock at a higher price than the ETF paid for it. In exchange, the option buyer pays a premium to the ETF, which the ETF gets to keep no matter what happens.
One net result of the covered call strategy is to limit the upside potential from owning a stock. So if a certain stock's price soars, the ETF won't benefit from the entire move, because it will have to sell out to the investor who bought the option from the ETF.
In exchange, though, the ETF's portfolio will produce more income than it otherwise would. Because the income from writing call options on shares belongs to the ETF no matter what, ETF shareholders can expect higher distributions than they would get merely from dividends and other income on the securities the ETF owns.
AdvisorShares is the first actively managed ETF using this strategy, and it therefore has a somewhat higher management fee than many ETFs at 1.35%. But other passive ETFs exist that use covered calls, including an offering from big industry player Invesco (NYSE: IVZ ) and its PowerShares ETF line. Recently, covered-call ETFs haven't been the best performers out there. That's largely because of how the market has behaved. When markets move up quickly, following a covered-call strategy often means having your stock called away at below-market prices as the options you write get exercised by the buyer. That costs you a big part of the profit you would have earned.
For instance, look at the PowerShares S&P 500 BuyWrite ETF (NYSE: PBP ) . It has returned a respectable 19.6% over the past year and grown at a 9.5% average annual clip over the past two years. But compare that with the S&P 500 overall, and you'll see that it lags substantially behind its 25% one-year and 15.5% average annual two-year return.
A look at the PowerShares ETF's holdings tells an even clearer story. Apple (Nasdaq: AAPL ) is the fund's largest holding at nearly 5% of assets, and because of the unprecedented success of all its product releases lately, Apple's share-price path upward has been far steeper than the overall market's trajectory. Similarly, General Electric (NYSE: GE ) has gained almost 50% in the past year on its continued recovery from the financial crisis and strength in its industrial sector, and eBay (Nasdaq: EBAY ) has soared more than 60% as its PayPal division assumes a leadership role in electronic and mobile payments and its core marketplace business bounces back from the recession.
Looking forward, though, it's far more questionable whether those accelerated gains will continue. Even if the market keeps going up, a modest pace of advance can actually be the best possible result for the covered-call strategy. If stocks fall, the ETF will probably lose ground, but the income it earns will help reduce the severity of the losses somewhat.
What the future will bring
Ordinary investors may be skeptical of Wall Street innovation, but every once in a while, a new product comes along at a time when it could actually do investors some good. Writing covered calls doesn't give you a whole lot of protection from a downturn, but if you think the market's ready for at least a brief respite, then the new AdvisorShares ETF may bring investors the right sort of exposure for today's market.
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