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Aptus Defined Risk ETF – Not Your Run-Of-The-Mill Bond ETF Offering (BATS:DRSK)

Brief Thesis

I recently discovered this ETF offering, and it surprised me by its features. For some time, I have been studying exchange-traded funds hunting for opportunities which cater to distinct investment mandates. A lot have comparably ordinary attributes or a bog-standard investment objectives – this one, however, remains very much left of center field, comprised almost wholly of medium-duration investment-grade corporate debt, it matches this with long at-the-money calls on US equity.

I remain upbeat about how this ETF style could play a meaningful role – especially in the present environment. A yield-less bond market matched with equities at all-time highs paints a worrying picture, specifically for the more risk-averse investor. This is where hybrids play their part – not delivering the returns of equity, but harboring less risk, special ETF constituents, such as the use of options, can provide an interesting investment proposal.

(Source: Market Chameleon)

Overview

Aptus Defined Risk (DRSK) affords investors the possibility of both fixed income and equity exposure through its hybrid structure. Predominantly comprised of US-denominated medium duration (7-8 years) investment-grade corporate bonds (90%-95%), the fund retains the equity “kicker” expressed through long call options on US equity. Hence, the product name – defined risk which is a terminology typically used to characterize long positions on options, in this instance, call options.

The fixed income component of the package is comprised of “bullet maturity” ETFs to build exposure to credit markets which it holds until maturity, rolling each one to later dater maturities as they come to term. The remaining part, between 5% and 10%, is used to buy call options on US equities.

Characteristics of the call options include 6-month maturities, purchased at the money, which are then rolled over on a quarterly basis. The call options are purchased on a handful of large-cap stocks, which are chosen for momentum and growth potential. In some instances, options on ETFs tracking large-cap stocks will be used as a substitute.

This unique strategy provides some degree of leverage and exposure to large-cap US equities using derivatives, which makes the product somewhat standalone.

Price Returns YTD Aptus Defined Risk ETF

(Source: Tradingview)

Returns have understandably remained below what a typical fully fledged equity ETF would deliver while being above what you would find in an all-inclusive corporate bond offering. This would accurately describe how the fund positions itself in the ETF space – something akin to a boosted US corporate debt ETF propelled by any active returns generated by long call options. An interesting proposition!

Top Holdings Aptus Defined Risk ETF

(Source: ETF Fact Sheet)

As previously emphasized, the fund’s composition is predominantly made up of fixed income securities against which call options are used to provide some degree of leverage. The thinking behind the design of the package was to provide investors with a hybrid proposal to the traditional 60/40 package.

As bond yields have been depressed, finding that yield to shore up an underlying portfolio has been increasingly difficult. Here, Aptus Capital Advisors proposes a more novel approach to meeting similar traditional objectives.

The call option part of the portfolio is what has helped propel returns beyond what a typical bond ETF would deliver. Long call options offer both leverage and defined risk, which neatly complement the bond component.

Example of some of call options used in Aptus Defined Risk

(Source: Aptus ETFs)

The call options embedded in the ETF are principally large-cap growth firms. Notwithstanding, there is no particular mandate on firms selected – in this instance, the ETF is holding energy derivatives (Chevron (CVX)), big tech (Facebook (NASDAQ:FB), Alphabet (NASDAQ:GOOGL) (NASDAQ:GOOG)), industrials (Danaher (DHR)) and even financials (Bank of America (BAC)).

Structure

Aptus Defined Risk falls into the category of hybrid ETFs. The ETF is among the newer products on the market, being launched around mid-2018. Interestingly, despite its hybrid components, the structure itself remains relatively standard – no leverage using OTC derivatives removes counterparty risk from the product. The derivatives that the ETF does have recourse to are standard options contracts available to any investor. Expense ratios appear reasonable, given the complex concoction of bonds and long calls, all of which would generate significant administration fees.

Assets under management are on the low side, which seems normal for a product which is not so standard and possibly a bit more difficult for investors to understand. A positive point the fund touts is its attractive dividend yield which would predominantly be derived from the coupons on the bonds. The year-to-date returns are a function of both fixed income and derivative aspects of the product, but arguably, it is likely the call options contributed meaningfully to the 13% year-to-date return.

(Source: Developed by author data supplied by ETF.com)

Call option mechanics

Undoubtedly, most Seeking Alpha readers have an in-depth understanding of derivatives – given this product’s overwhelming reliance on them as a contributing factor to returns, I thought a quick recap of a call options mechanics would be worthwhile.

Call options allow the buyer of the option the right to purchase the underlying, for example, Apple Inc., stock (AAPL) at a certain strike and a certain maturity date.

  • Options fall into the broad family of derivatives and are used as instruments to effectively manage risk – whether this means magnifying gains through leverage or protecting a stock, bond, or other security from losses.
  • Like bonds, options have a lifespan and therefore buyers of the option are exposed to time decay (theta)
  • Options are exposed to a range of concepts defining their behavior known as “Greeks” – the important one to consider for here is that the ETF is buying 6-month at-the-money calls. At-the-money calls have a delta – the Greek which describes the movement of the option relative to the movement of the underlying stock – of 0.5. This signifies that, if the underlying gains $1, the value of the derivative will gain $0.50. Essentially, 2 long at-the-money calls have a delta of 1, which is approximately the same as 100 shares. The synthetic position would thus move roughly like the underlying.

Pay-out diagram of a long call option on Apple Inc. (AAPL)

(Source: Market Chameleon)

In the diagram above, the pay-out of a $120 call on Apple Inc. is mapped out. The bottom axis has the different prices the underlying stock may take and the line – sometime red, sometimes green – describes how the call option will be in relation to changes in the price. Note, most importantly, that from $120 and below, the redline flatlines out – this is the maximum the position can lose (in this instance approximately $1,200) hence the use of the terminology “defined risk”. The long option cannot lose more than $1,200. Long options have limited risk, unlimited (theoretical gains).

As the value of Apple Inc. stock increases, so does the value of the long call. Initially from about $120 to roughly $132, the option starts to cover the cost to buy the call as it moves to the break-even point (around $133) From then onwards, the long call option will continue to gain as long as the underlying stock AAPL progresses north.

At expiry, if the underlying stock is, for example, $150 – the $120 call option entitles the holder to buy the stock for $120. If the underlying stock finishes, for example, at $90 – the call option will expire worthless, and the maximum loss the holder will suffer is the price paid for the option.

This emphasizes the important aspect of Aptus Defined Risk ETF – it is full of call options which have the potential, specifically in bullish markets, to rapidly propel ETF returns through the leveraged effect of the options. It makes for an interesting cocktail, particularly in this instance, where most of the holdings contain lower risk corporate investment grade bonds.

Key Takeaways

The Aptus Defined Risk ETF makes for a very compelling proposal. Not alone in this segment, the ETF does creatively use the distinguishable traits of multiple asset classes and marries them efficiently to produce something with gains superior to corporate debt while providing some of the less risky characteristics of pure equity. In doing so, it showcases some of the positive aspects of ETFs, relatively low costs, tradable assets and in this instance, tailor-made or hybrid investment proposals.

In a yield-less bond environment which has pushed risky equities to all-time highs, hybrid ETFs like Aptus Defined Risk are worth a look.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I hope you enjoyed my ETF analysis which is part of a wider series of ETFs I have been reviewing. Check out my Seeking Alpha to find additional ETF analysis and please hit the like button. Thank you.

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