One of the hottest products for retail investors the last couple of years is the single-stock option-income exchange-traded fund. While the basic idea is similar to the old and respectable covered-call writing strategy, the modern versions grabbing attention and dollars are supercharged, promising income yields of 100% or more.
The largest such fund is the Yieldmax TSLA Option Income ETF, or TSLY, which takes long and short positions in call and put options on Tesla Inc., or TSLA, shares. The fund is actively managed to have a generally long exposure to Tesla stock, to generate substantial income from net selling of options, but in return to forego some of the upside if the stock rises, while suffering increased losses if the stock goes down. While this can be a useful tool for short-term speculators, it shares with leveraged and inverse ETFs an Achilles’ heel for long-term investors.
The chart below shows the daily returns on TSLY versus the returns on TSLA since the fund’s inception. The blue dots are the actual returns, the curving line is my calculation of what a long-term investor should expect on average — the variation of the blue dots around the line should average out over long holding periods.
This pattern might be appealing to an investor making a one-day bet. If TSLA doesn’t move, TSLY returns an average of 0.21%, which annualizes to 69%. If you think TSLA will go up a lot (more than 0.65%), you’re better off buying the stock. If you think TSLA will drop more than 0.29%, you’re better off avoiding both TSLA and TSLY. But in between, TSLY beats both TSLA and money markets.
The view for a long-term investor is entirely different.
Since TSLY’s inception, TSLA has had an average daily return of 0.08%. Multiply that by the 312 trading days till the end of last week, and it comes to about 25%. But the actual return of TSLA over that time was only 5%. A long-term investor does not earn the average daily return, but instead a return that includes “volatility drag.” The drag arises from the sad fact that if a fund goes down 10% and up 10%, the investor has a net loss of 1% — regardless of the order of the two events, how long they take or how big the equal up and down moves are.
A long-term TSLY investor can expect an average daily return equal to 0.21% (what you get on days TSLA doesn’t move) plus 0.7 times the daily return on TSLA minus four times TSLA’s volatility drag (based on the fund’s strategy and standard option pricing assumptions). So, 70% of the stock’s return and four times the volatility drag, and that’s before subtracting TSLY’s own volatility drag. If you wait long enough, the extra volatility drag will offset the 0.21% fixed return — meaning a TSLY investor almost has to lose money in the long run.
It’s important to note that the long run can be very long. TSLY could make money for a year or several years. There’s no deadline for the math to kick in. In the perfect world for TSLY, TSLA goes up steadily, without big moves, but the implied volatility used to price its options remains high. That could happen for a while, but not forever. Sooner or later, TSLA will make big moves, or option buyers will lower their implied volatility. Or TSLA will simply go down. Most investors will hold TSLY in a taxable account, making the taxes unfavorable as well.
Single-stock option-income ETFs do have one feature that sets them apart from leveraged and inverse ETFs. While it does not make them suitable as long-term portfolio holdings, it can make them reasonable intermediate-term purchases. The funds pay high dividends. If you bank or spend the dividends rather than reinvesting them, you escape some of the volatility drag.
The chart below shows the result of buying TSLY at inception on Nov. 23, 2022 and putting all dividends in one-month Treasury bills rather than using them to buy more TSLY. You can see the value of the ETF (in blue) falls pretty steadily, although it has occasional up months, but the losses are offset by the value of your accumulated Treasuries. Today your Treasuries are worth more than your TSLY. You’ve had a small loss over five quarters of investment, but with better luck in the future you may find that you get a good return even if TSLY goes to zero.
The key is that taking money off the table can be a partial antidote for volatility drag. You could do the same thing with a leveraged or inverse ETF, but you’d have to make active trading decisions. With an option-income ETF, you can just collect the dividends and put them in money markets, Treasuries or other investments — or just spend them.
I still don’t like this product for its long-term decay, high fees and tax disadvantages, but I like it better held for income with dividends reinvested elsewhere than as part of a long-term portfolio.
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