Although interest rates have risen from their longer-term lows, the yield on the 10-Year U.S. Treasury is bouncing around 3%, unsure of where to go next. And that still-paltry yield is why there’s been no shortage of investment products engineered to deliver extra yield to investors.

That includes buy-write exchange-traded funds and exchange-traded notes, which employ covered call and put-writing strategies designed to generate additional income and provide a degree of downside protection. Call-writing strategies involve buying a stock (or a basket of stocks) and offsetting that by selling or writing a call option on those stocks (an option to buy a security at an agreed-upon price by a certain expiration date). Call options earn a premium for the seller, who benefits by keeping both the premium and the underlying stock in a flat or slightly falling market. But in rising markets, the underlying security is sold at the agreed-upon strike price and the seller keeps only the premium on selling the call option. The upshot: This strategy isn’t ideal in bull markets because it caps the upside potential for the seller.

Put-writing involves selling a put option that gives the buyer the right, but not the obligation, to sell the underlying stock or basket of stocks at the agreed-upon exercise price by the specified expiration date. Buying a put option is a bearish bet because the buyer profits only if the security’s share price falls below the strike price, which allows the buyer to sell the stock at a certain price and then buy it back at a cheaper price. If the underlying security appreciates in value above the strike price, the buyer loses only the premium paid to buy the option. Put options earn a premium for the seller, but the seller could lose money if the asset price falls below the strike price and the buyer exercises the option at the strike price.

Available Options

Investors looking to limit the downside of their investments not only have put and call options to turn to but also indexes and the funds that track them. One of these is the CBOE S&P 500 BuyWrite Index. This index owns an S&P 500 portfolio and sells the equivalent number of near-term, slightly out-of-the-money S&P 500 covered call options, generally on the third Friday of each month. (Out-of-the-money calls have a strike price that’s above the current trading price of the underlying security.)

The CBOE S&P 500 PutWrite Index, meanwhile, measures the performance of a hypothetical portfolio that sells S&P 500 put options against collateralized cash reserves held in a money market account at one- and three-month Treasury bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in T-bills can finance the maximum possible loss from the final settlement of the S&P 500 puts.

A study done by Hewitt EnnisKnupp, an investment consulting company, found that from June 1986 through January 2012 the CBOE S&P 500 BuyWrite Index produced comparable returns to the S&P 500 but with lower volatility. In addition, Ennis Knupp + Associates (before it was bought by Hewitt Associates) did a study that found the CBOE S&P 500 PutWrite Index earned higher returns than the S&P 500 with lower volatility from its 1986 inception through mid-2008.

Sounds great, but that’s old news and it’s not so clear whether buy-write funds have delivered the goods in recent times. The oldest buy-write fund is the Invesco S&P 500 BuyWrite ETF (PBP), which based on the CBOE S&P 500 BuyWrite Index. The strategy works by holding a long position indexed to the S&P 500 Index and writing, or selling a succession of covered call options with an exercise price at or above the prevailing price level of the S&P 500 Index. Dividends paid on the component stocks underlying the S&P 500 and the dollar value of option premiums received from written options are reinvested. PBP’s recent 12-month distribution was 3.23%.

The Invesco fund produced a 4.75% annualized return for the 10 years ended June 29, 2018. That’s more than five percentage points lower on an annualized basis than the SPDR S&P 500 ETF’s (SPY) 10.17% annualized return over the same period. PBP achieved its return with lower volatility than the SPY Fund—a 10-year standard deviation of around 11% versus  14.7% for SPY. But that lower volatility hasn’t been low enough to compensate for the lower return. PBP’s Sharpe ratio (the measure of its volatility-adjusted returns or return per unit of volatility) of 0.45 was considerably less than SPY’s ratio of 0.71 for the past decade.

Another fund in this category is the Horizons S&P 500 Covered Call ETF (HSPX), which tracks the CBOE S&P 500 2% OTM BuyWrite Index. That index buys a S&P 500 stock portfolio and writes near-term 2% out-of-the-money calls that correspond to that portfolio. That means the exercise price is 2% above the prevailing index level.

The fund’s annual distributions between 2014 and 2017 ranged between 2.78% and 5.17%—the latter figure was attained last year.

HSPX has a better five-year record than the Invesco fund, posting a 9.24% annualized return versus Invesco’s 7.38% annualized return for the same period. That outperformance may not necessarily continue in a down market. The Horizons fund also has a more pleasing 0.65% expense ratio, which is 10 basis points cheaper than the Invesco fund.

The Active Approach

Investors have three active buy-write options, too, including the First Trust BuyWrite Income ETF (FTHI) that invests in equity securities of all market capitalizations listed on U.S. exchanges and then sells call options on the S&P 500 Index to collect a premium that’s distributed monthly to investors. The fund’s objective is to provide income first, and capital appreciation second. Its 12-month distribution rate as of May 31 was 4.21%.

FTHI, along with its all-cap sibling fund, the First Trust Hedged BuyWrite Income (FTLB), both have expense ratios of 0.85%, which is on the high side among funds using options strategies. Over the three years through June 29, the First Trust BuyWrite Income fund’s 8.33% annualized return has outpaced the Invesco fund’s 6.88% return, but not the Horizon fund’s 8.80% return.

The First Trust Hedged BuyWrite Income fund follows a somewhat similar strategy as the First Trust BuyWrite Income ETF, but rather than simply writing covered call options on the S&P 500, it creates a hedge by buying put options on the S&P 500 and selling covered call options on the index. Its recent 12-month distribution rate was 2.91%

The third choice is the Amplify YieldShares CWP Dividend & Option Income ETF (DIVO), which sells call options against a base portfolio of up to 25 dividend-paying stocks. This fund aims to provide gross annual income of 2% to 3% from dividend income and 2% to 4% from selling option premiums. DIVO doesn’t have a three-year record yet, but it returned 14.5% during the past year versus 12.2% for the S&P 500 (through June 29). Its expense ratio of 0.96% is the second-most expensive in the category.

Selling Puts

On the put-writing side, WisdomTree has two entries: the CBOE S&P 500 PutWrite Strategy Fund (PUTW) and the CBOE Russell 2000 PutWrite Strategy Fund (RPUT). The S&P 500 strategy receives a premium by selling a sequence of one-month, at-the-money S&P 500 puts. If the value of the S&P 500 falls below the strike price of a put on the index, the option finishes in-the-money and the fund pays the buyer the difference between the strike price and the value of the S&P 500. If the index declines, the fund will suffer losses, which will be partially offset by the amount received from the premium. The Russell 2000 fund functions the same way, the obvious difference being it deals with Russell 2000 Index put options.

Finally, a group of Credit Suisse funds, the X-Links series, consists of exchange-traded notes (which are unsecured debt securities) that provide access to various asset classes, market sectors and/or investment strategies. One example is the Credit Suisse X-Links Crude-Oil Shares Covered Call ETN (USOI), which sells calls on the United States Oil Fund (USO). Unfortunately, USO tracks the daily price moves of WTI (West Texas Intermediate crude), but not the long-term price movements. So while the price of WTI is down from more than $135 in 2008 to less than $70 today (a decline of roughly 50% over the past decade), USO is down much more—around 18% per year or more than 85% cumulatively, according to fund researcher Morningstar. If USO doesn’t do a good job tracking the long-term price moves of oil, it’s unclear how well the USOI fund will work. While USOI had a great first half this year with a nearly 10% return, investors should be wary of these funds, particularly as longer-term holdings.

Conclusion

Besides the potential problems of the oil-related funds, the stock-related options-writing funds have failed recently on a second front. Not only have these funds not beaten the S&P 500 in recent years, but the oldest one, the Invesco PowerShares BuyWrite fund, has failed to beat the Vanguard Balanced Index Fund (VBIAX), an index mutual fund with a 60%/40% mix of U.S. stocks and bonds. The 7.98% return of the Vanguard mutual fund exceeds that of the Invesco ETF by more than 3 percentage points annually for the past decade. The Vanguard fund also achieved its superior return with a standard deviation of less than 9.2%, according to Morningstar, beating the buy-write strategy, with its 11% standard deviation, on both returns and volatility.

Among this entire group, only the Invesco S&P 500 BuyWrite fund has a 10-year record and can claim to have gone through a full cycle. The fund has indeed performed as advertised: It fell “only” 29% in 2008 while the S&P 500 fell 37%. But that hasn’t been enough to overcome its weakness in more recent years.

It may be that the stock market’s surge and low downside volatility since 2009 have provided a uniquely bad environment for funds that seek to protect against a market retreat that hasn’t happened. A spate of volatility may make them look good again against the S&P 500. But investors should understand that they will have to endure long periods of underperformance for the stock-related funds to deliver on their mandate of market-like or market-beating returns with less volatility.    

John Coumarianos, a former Morningstar analyst, is an analyst and advisor at Clarity Financial in Houston.