SPD ETF: An S&P 500 fund with a layer of protection

As the market continues to hit record highs there has been growing interest in how to stay invested but at the same time provide downside protection in the easiest way possible. Unsurprisingly, new ETFs are popping up to provide those kinds of solutions, such as the SPD ETF by Simplify.

Basically Simplify is trying an old strategy by overlaying hedge fund-like functions to protect against downside risk for stocks and interest rates volatility. They seek to provide access to sophisticated portfolio tools that traditionally have been only available to the largest institutional investors like hedge funds.

By succeeding, they would reinvent what can be done inside an ETF and disrupt the classic 2/20 scheme of hedge funds through providing hedging solutions in a cheaper and more liquid form, the SPD ETF.

How does the SPD ETF work?

The SPD ETF is a fund that passively invests in iShares Core S&P 500 ETF (IVV) but with a twist. The ETF actively uses put options overlays (1-2% of NAV) to hedge against downside when markets go under.

Reminder of how options work

Options are a contract that gives the buyer the right to either buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a pre-determined price by a specific date. Options are a powerful tool for creating a wide array of payoff profiles and can be used on a standalone basis or integrated into a broader portfolio strategy

They have the following characteristics:

• Expiry Date: Options come with a defined expiry date. This remains unchanged until the validity of the contract. If the option is not exercised within this date, it expires.
• Premium or down payment: The holder of this type of contract must pay a certain amount called the ‘premium’ for having the right to exercise an options trade. If the option was not exercised the premium is lost. Usually, the premium is deducted from the total payoff, and the investor receives the balance.
• Strike price: A strike price is the set price at which an option contract can be bought or sold when it is exercised. For call options, the strike price is where the security can be bought by the option holder; for put options, the strike price is the price at which the security can be sold.
• Intrinsic value: An intrinsic value is the difference between the strike price and the current price of the underlying security.  

An example of how “Put” options work:

Suppose an investor buys a put option of Trackinsight (if we get listed someday) on a certain date with the term that he can sell the security any time before the expiration date for $100. If the price of the share falls to below $100, say to $85, he can buy the shares at price and sell the stock through his option at $100, netting a $15 gain.

In case the share price rises to $120, the holder of the put option is under no obligation to exercise it, but if the option expires, the premium paid for it will be lost. To sum it up, if the price of a security is falling, a put option allows a seller to sell the underlying securities at the strike price and minimize his risks.

SPD ETF purchased several put options

SPD has bought several put options, with slightly different characteristics. One of them is a SPDR® S&P 500 (SPY) Sep 2021 440 Put.

To put things into perspective:

• When SPY moves up and stays above the $440. In that case, the put option made by SPD expires (since its worthless) and the ETF underperforms by roughly the amount invested in the options (premium paid)
• In case of a huge SPY crash in September, in which the price drops to $400 the put options can be profitably exercised. SPD would simply buy the shares at market price (e.g $400) and sell them through their options at the strike price (e.g $440) to pocket the spread.

Hence, the SPD is designed for investors who are willing to sacrifice higher potential returns during bull markets for the sake of protection during downturns.

SPD ETF and its performance

Since its inception on March 9th, 2020 up until August 31st, 2021, SPD has underperformed the S&P 500 Index Total Return by more than 4 percentage points (28.44% to 32.68%). The difference is expected since the put options have expired during the S&P 500's record-beating runs, incurring losses that translated into underperformance of the SPD.

ETFs that use options are a small, yet growing trend

ETFs that use options have attracted around $5 billion in the last year, a sign that investors are becoming more interested in hedging strategies that aim to protect their portfolios even as the market breaches new highs.

In addition to the SPD ETF, Simplify has launched two other ETFs that implement similar strategies with S&P exposure, the Simplify US Equity PLUS Convexity ETF (SPYC) and Simplify US Equity PLUS Upside Convexity ETF (SPUC). They also have a wider range of funds, including other convexity, volatility and concentrated thematic ETFs. In total, they have amassed more than $688 million in assets under management.

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