So far 2014 is looking like what could be called a bungee market: Stock prices plunge dramatically, then snap back to roughly where they were before. The VIX, an index that tracks volatility, recently hit a 12-month high.
New ETFs aim to smooth those bounces and boost returns using “covered calls.” Investors in individual stocks have traditionally used the calls in high-volatility, low-return markets. Here’s how they work: Investor A sells such a call (also known as a “buywrite”) on a stock he already owns to Investor B. Investor A receives cash in exchange for the obligation to sell the shares at a particular strike price and time. If the stock stays flat or falls, Investor A pockets the cash and holds on to his shares. If the stock rises, he keeps the cash but probably has to sell the shares, thereby giving up some of the gain.
Historically this technique has succeeded in bumpy markets. Covered call strategies beat the Russell 2000 between 1996 and 2003 and then again between 2007 and 2011 (with less volatility), but lagged during the 2003-07 bull market, according to research from the University of Massachusetts. In the past five years the CBOE S&P 500 BuyWrite Index has bounced up and down less than the S&P, with 11% variance for the former and 15% for the latter.
The PowerShares S&P 500 BuyWrite Portfolio buys all the stocks in the S&P 500, then sells “at the money” calls on the index, meaning the managers sell options with a strike price set at the price of the index at that moment. (The ETF fell less than the S&P 500 during the 2008 crash but has trailed it badly during the subsequent bull market.) The Horizons S&P 500 Covered Call ETF, launched in June, uses a similar strategy but sells “out of the money” calls on individual stocks, meaning the strike price is above the current price.
The difference between the two is small but important. Investors pocket less cash from an out-of-the-money call than from an at-the-money call on the same stock because the former offers Investor A a bit of the profits if the stock price rises, so there is a chance at a greater overall return. The University of Massachusetts study showed that the out-of-the-money strategy has performed slightly better over time.
Buy-and-hold ETF investors are usually best served by riding out the bumpy prices. Bill Sharpe, a Stanford professor emeritus and developer of the Sharpe ratio, which adjusts returns to take risk into account, says he thinks the covered call ETFs are “by and large a bad idea.” But for a person who needs to shield a portfolio from volatility for, say, six months, there could be a benefit. As Sharpe puts it, “There are arguments for cases in which people’s preferences are such that they might want some option-like outcome.” If you’re in that category and you agree with the consensus of Wall Street analysts, who predict a 5% gain for the S&P between now and the end of the year, a small investment in the Horizons fund may be helpful. If you’re less optimistic, the PowerShares fund might make the next market move a bit less bungee-like.
This story is from the March 17, 2014 issue of Fortune.
