Producing alpha is the Holy Grail of active investment management, and most people attempt to generate returns exceeding a benchmark index by relying on hands-on stock or bond picking. And when people think of investment alpha, they often dream of achieving outsized returns well above the benchmark.

The folks at Liquid Strategies LLC have a different take on the pursuit of alpha that has nothing to do with active stock or bond selection, or with generating boffo alpha above the benchmark. The Atlanta-based investment management firm this week rolled out the Overlay Shares suite of five actively managed exchange-traded funds that employ an options overlay strategy over a specified benchmark index. The strategy is designed to create additional returns above a benchmark over time with little change in the overall risk profile.

The Overlay Shares ETFs take a minimalist approach to portfolio construction: four of the five funds in the suite contain just one holding in the form of an ETF that tracks a specific index for either stocks or bonds, depending on the fund’s objective. The fifth product has two underlying ETFs. The Overlay Shares roster comprises the following:

• Overlay Shares Large Cap Equity ETF (OVL)

• Overlay Shares Small Cap Equity ETF (OVS)

• Overlay Shares Foreign Equity ETF (OVF)

• Overlay Shares Core Bond ETF (OVB)

• Overlay Shares Municipal Bond ETF (OVM)

The large-cap OVL fund illustrates how the options overlay strategy works. This fund takes a 100% long position in large-cap equities via its lone holding, the Vanguard S&P 500 ETF (VOO). It also sells short-term put options on the S&P 500 Index with a notional value (i.e., strike price times the value of the shares) up to 100% of the fund’s net assets and buys an equal number of short-term put options with a lower strike price. The fund aims to capitalize on the inefficiency of options pricing by generating income via the “put spread” between these options.

“Our overlay is strictly a premium collection mechanism where we collect an incremental premium from our overlay,” says Brad Ball, co-founder and CEO of Liquid Strategies. “We give you all of the returns of the underlying index, plus the incremental overlay on top of it.”

Liquid Strategies formed in 2013 and has been using its options overlay strategy in separately managed accounts for high-net-worth investors. The company put the strategy into ETFs to make it more accessible to retail investors.

All five Overlay Shares ETFs have a management fee of 0.75%. “Our funds are very actively traded, so 75 basis points is very competitively priced for an active strategy,” Ball says.

And whether it’s for a stock or bond fund, the options overlay for all five ETFs in this group consists of an actively managed strategy of selling puts against the S&P 500 index.

Ball notes that the overlay strategy has typically generated incremental returns of 3% to 5% above the returns of an underlying index, but has averaged a little more than 3% since the strategy’s inception. He adds this strategy aims to reduce volatility while creating a consistent, repeatable stream of returns for investors. 

“The volatility risk premium associated with selling options is the amount of premium you collect versus the amount of losses you incur,” Ball explains. “The options we’re selling offer downside protection on the S&P 500, and in 29 of the past 30 years those options have had a positive risk premium. That means if you sold downside protection with options against the S&P 500, in 29 of those years there was a positive outcome.”

As such, he posits the Overlay Shares ETFs are designed to be long-term core holdings in investor portfolios.

All-Weather Design

Ball offers that traditional buy-write options strategies typically are defensive because investors are willing to give up some of the potential upside of the underlying index in return for income and dampened volatility. He says his firm’s options overlay approach doesn’t give up any upside in an index, and is neither a bull- nor bear-market strategy.

“It’s just an overlay that sits on top of portfolios and is relatively timeless,” Ball says. “A large-cap fund with an overlay is just a better large-cap fund with an alpha engine. It’s the same thing with all of our ETFs. It’s a passive index, plus an alpha engine of 3%.”

But not always. Ball acknowledges his firm’s options overlay strategy produces extra alpha to an underlying index when the markets are up, flat, or slightly down. “It’s only if the market is down by more than 2% or so that we begin losing,” he says, adding that the spread between selling and buying put options for downside protection cushions losses on the overlay strategy during down markets.

“The maximum loss my overlay creates is about slightly less than a 3% loss,” Ball says. “We don’t have catastrophic losses [on the overlay], but we can have small losses than can add up over time.”

The overlay turned negative during last year’s fourth-quarter sell off. “Prior to last year we had been averaging about 5% [alpha to the underlying index], but last year’s performance pulled the average down to 3%,” he says.

Keep in mind that all five of these ETFs are 100% long to their underlying indexes, so the ultimate performance of the funds will live and die with their respective beta expsoures. If, for example, the Vanguard S&P 500 ETF in the Overlay Shares Large Cap Equity ETF loses 30% and the overlay is negative 3%, that ETF will lose more than its index. Conversely, if VOO zooms, then the fund will benefit from its overlay alpha boost.