I last covered the XYLD in January last year, when I argued that high levels of implied volatility would allow the ETF to generate strong option income, which would likely outweigh the impact of any capital gains in the S&P 500. Since then, the XYLD has returned a decent 16%, with these returns coming almost entirely from option premium income. A lot has changed since then, however. Specifically, 1-month implied call option volatility has fallen by around a half, while the S&P 500’s valuations have risen to extreme levels while market breadth has collapsed. The income that the XYLD is likely to generate is now no longer worth the risk of a large drop in the market, and any spike in volatility could actually see the ETF underperform the S&P 500 even under a declining market scenario. I am therefore shifting by recommendation from a hold to a strong sell.
XYLD Price and Total Returns Rebased to 2013 (Bloomberg)
The XYLD ETF
The Global X S&P 500 Covered Call ETF (NYSEARCA:XYLD) tracks the performance of the CBOE S&P 500 BuyWrite Index, which holds the S&P 500 and writes calls against it in order to earn the option premium. The XYLD is similar to the JPMorgan Equity Premium Income ETF (JEPI) with the main difference being that the former sells at the money options rather than slightly out the money options, which allows for greater option income at the expense of lower potential for capital gains. The XYLD was launched in 2013 and since then, it has significantly underperformed the S&P 500 as capital gains have been particularly strong. The current dividend yield on the ETF is 9.5% which takes into account the 0.6% annual expense fee.
Collapsing Implied Volatility Points To Weak Option Income
Covered call strategies such as the one employed by the XYLD make sense as an alternative to simply buying the underlying market when levels of implied volatility are high. In January 2023, the ETF yielded over 13% on a trailing basis due to elevated levels of implied volatility. However, since then, implied call option volatility has collapsed, with the price of a 1 month 25 delta call option falling from almost 20 to below 10.
1-Month 25 Delta Call Volatility (Bloomberg)
This is almost a full standard deviation below the long-term median of 12.3%. Similarly, low levels of implied volatility in the past have resulted in the XYLD generating annual income returns of just 5-6%.
Extreme Valuations And Declining Market Breadth Raise The Risk Of Steep Declines
Low implied volatility is not only likely to undermine income returns but also raises the risk of a large market drop should sentiment shift, which could easily wipe out the impact of option income. This risk is heightened by the fact that S&P 500 valuations are once again up at extreme levels, with the PE ratio rising from around 18x last January to 25x today.
S&P500 PE Ratio Vs Call Option Volatility (Bloomberg)
There have been periods where high valuations and low implied volatility have remained in place for a time. This occurred in 2017 and allowed the XYLD to post impressive returns of 17% for the year. However, not only are valuations more expensive than they were back then, but the market is now much more beholden to the performance of a small number of stocks. For instance, in 2017 the share of S&P 500 stocks hitting new 52-week highs was consistently much higher than the share hitting new 52-week lows. In contrast, recent all-time highs have been driven by a tiny number of mega cap stocks, most notably Nvidia and other AI beneficiaries, which raises the risk of a sharp market decline if these stocks begin to falter.
XYLD May Not Even Outperform The S&P 500 During A Bear Market
As I am bearish on the US stock market, I still expect the XYLD to outperform the S&P 500 over the coming months and year, as is typical during bear markets, as capital losses are at least supported by option income. However, even if the market does decline, it is by no means guaranteed that the XYLD will outperform. If we see sharp declines in the S&P 500 and strong bear market rallies, the XYLD would suffer capital losses on the way down but not benefit from the upside from the relief rallies. While this is an unlikely scenario, current low levels of option income makes the XYLD particularly unattractive from a risk-reward perspective.
Summary
I have shifted my view on the XYLD from a hold to a strong sell since my last comment in January last year, owing to a combination of collapsing implied volatility and heightened risk of a large decline in the S&P 500. The XYLD now offers insufficient income to compensate for the potential capital loss that could occur if sentiment turns bearish and downside volatility spikes.