SVOL: The Hedge Worked, I Maintain A Strong Buy (NYSEARCA:SVOL)

Introduction

The Simplify Volatility Premium ETF (NYSEARCA:SVOL) is a short volatility fund aiming to produce 15% annual returns, primarily via monthly income distributions. It is a fund that relies on the skill and timing of its managers, and the smart folks over at Simplify have proven themselves over the last few years.

The fund operates as a trading vehicle, wherein the ETF wrapper, the fund managers sell futures against the VIX. They also play around with the fund’s collateral in bond positions and sell options spreads. It is a very complex fund with a lot of moving parts, but the chart below will speak for the worthwhileness of its complexity.

Background

I have been a public proponent of SVOL since I began writing on Seeking Alpha back in October 2023. In my last article, I recommended adding up to a 15% allocation to SVOL in an income portfolio; that is to say that I am very bullish on this fund and its strategy.

I have covered SVOL several times before this, and I encourage you to check out the timeline of my past coverage and where I have stood in the past. This article is just the latest update in the SVOL saga. Since the fund is actively managed and is charting new territory, it is essential that we have the context. Here is the timeline of my previous coverage, for reference:

SVOL: Changes In Bond Holdings Are A Boon – October 2023

SVOL: Downgrading Due To Concerning Trends – November 2023

SVOL: Trends Reverse, Reinstating My Buy Rating (Upgrade) – January 2024

SVOL: I Am Pleased With The New Holdings (Upgrade) – April 2024

Since then, I have been fairly quiet, but have maintained my “strong buy” rating on SVOL. Up until recently, there wasn’t much to talk about. The fund was churning along as expected, and performing like a well-oiled machine.

Catching Up from April to Now

It was April 15th when I issued the strong buy rating on SVOL. For a few weeks, my call was well-timed and performed as expected.

All of the charts in this section begin on April 15th.

Then the VIX exploded…

…but just for a little bit.

Like most VIX spikes in the past, this one was sudden, unexpected, but over with quickly.

As I have predicted in the past, in the event of a spike in the VIX, SVOL will see an immediate crash in price. Then, the hedge will kick in, and the fund will recover much of its price loss by selling off the VIX call options they hold.

This is exactly how it played out.

The actual mechanics of what happened here are fascinating. I recommend reading Simplify’s breakdown of the crash and how they navigated it. The fund’s risk management played out exactly as expected, and shareholders were never too far in the hole during the spike. The recovery was very quick, and the fund stayed intact.

The Hedges Worked

Simplify posted this backtest in their article, and I want to highlight it here. This is how SVOL compared to a daily-reset 25% short VIX fund, meaning that the comparative data is between a passively managed short VIX fund and SVOL. Did the active management work?

It absolutely did. The delta on the total return between the two instruments is Grand Canyon sized. This is one of the reasons why I have been listing active management as a boon for this fund, and a positive that investors should be willing to pay for. The VIX is a fickle beast, and one I would not want to be passively short.

This helps justify SVOL’s higher-than-market-average ER of 0.5%.

Note: SVOL’s management fee is sometimes reported incorrectly as 1.16%. That is because leverage expenses are lumped into ER. The management fee itself is 0.5%.

Current Holdings

The Simplify Volatility Premium ETF has a very interesting holdings sheet, chock-full of derivatives and other ETFs, mostly other funds owned by Simplify. While this “incestuous” relationship with Simplify’s other funds is a conflict of interest, I understand why the fund managers have taken these positions and believe that the ETFs they have chosen just simply are the best positions to take for this fund.

The core positions in ETFs are exactly what I want to see right now. They are all funds that are adding convexity to their strategies. This is a really shallow overview of these funds, but I am going to try and quickly give a one-liner of why I believe each fund is in SVOL and what its advantage may be based on its construction. Where I can, I will link articles I have written in more depth on these funds.

• Simplify Aggregate Bond ETF (AGGH) – 9.58% AUM
• Simplify Stable Income ETF (BUCK) – 9.33% AUM
• Simplify High Yield PLUS Credit Hedge ETF (CDX) – 2.63% AUM
  • High-yield bonds, mostly corporates
  • Employs a hedge using credit default swaps (“CDS”)
  • CDS are institutional tools and are typically unavailable to retail investors, making this fund special in that regard
• Simplify Enhanced Income ETF (HIGH) – 6.65% AUM
• Simplify MBS ETF (MTBA) – 4.74% AUM
  • Newly issued mortgage-backed securities (“MBS”)
  • Since interest rates have risen, mortgages now yield 6%+, while old mortgages yield closer to 3%
  • By the fund only investing in new issues, it excludes all of the old, low yield mortgages sold during the ZIRP era
• Simplify Intermediate Term Treasury Futures Strategy ETF (TYA) – 4.77% AUM
  • 3x Leveraged 10YR US Treasury Bill, secured by T-Bills
  • Provides the yield of T-Bills minus the 10YR UST (currently positive carry), and duration of leveraged 10YR UST (16-20 duration)
  • These attributes set up for a potential 20% CAGR over the next two years, based on what the Fed has projected
  • I wrote about this trade last week in greater detail

These positions all attribute to SVOL’s returns, including its short VIX position, and have ensured that the dividend payouts have remained stable.

Some Risks Are Still Present

These funds all have one thing in common that we need to discuss, the elephant in the room: derivatives are used to add alpha.

Every time a fund uses an options overlay, they are adding volatility risk to the portfolio. Some of this risk is obscured through SVOL’s holdings, but when you add them all up together, you have some large exposures to very particular options trades like short spreads on the S&P 500 and bond indices. BUCK, HIGH, AGGH, and SVOL may all be stacking similar trades or options trades that have similar exposures, and this stacked risk is not apparent from the outside. It is almost impossible to track these risks because the funds trade every day, sometimes intraday, and only publish their changed holdings at the end of the day.

While SVOL survived this latest spike, it is still not immune from VIX spikes. A far worse spike could inflict far more damage to SVOL’s NAV, and it’s unclear how bad it could get, potentially a wipe-out.

Conclusion

I am still standing by my strong buy recommendation, and recommend the following:

• Do not worry too much about your SVOL cost basis, try to buy under $22
• Aggressive income investors should consider up to a 15% allocation to SVOL
  • The same recommendation I made in April
• Conservative income investors should consider up to a 5% allocation to SVOL
  • Upgrade from my previous recommendation of 0%

For now, I consider SVOL still the best-in-class short volatility ETF and one of the best income ETFs on the market. It has proven itself in the event of tail risk, something that has previously been a major risk. While the risk of a fatter tail always looms ahead, the risks have been reduced and conservative investors may find comfort they didn’t have before after SVOL’s recent outperformance of passive short volatility funds.

Thanks for reading.