NEW YORK (TheStreet) --Exchange-traded fund provider First Trust launched three new funds last week, including the First Trust Low Beta Income ETF (FTLB) - Get First Trust Hedged BuyWrite Income ETF Report.
Investors closely following the ETF industry will note that FTLB picks up on two popular trends of the last couple of years: low volatility and income.
A third popular trend captured by FTLB is that it is an actively managed fund. The basic strategy is an equity portfolio comprised of large-cap domestic stocks with an option strategy to both generate income and provide a hedge.
The equity portfolio is constructed based on a proprietary process that considers fundamental factors such as operating cash flow, share buybacks, debt and dividends. The portfolio will favor dividend-paying stocks.
The portfolio allocates 17% to technology stocks, 14% to consumer staples, 13% to consumer discretionary and 12% each to health care and financials.
The larger positions in the fund are mostly familiar companies, including Johnson & Johnson (JNJ) - Get Johnson & Johnson (JNJ) Report at 5%, Altria (MO) - Get Altria Group Inc Report 4.5% and General Electric (GE) - Get General Electric Company (GE) Report 4.2%. A couple of surprises in the top 10 are Seadrill (SDRL) - Get Seadrill Ltd. Report, which sports a generous 9% dividend yield but carries a heavy debt load, and Priceline (PCLN) , which has no dividend and is quite volatile.
The reason a volatile stock with no dividend is in the fund -- Priceline is not the only one; Google (GOOG) - Get Alphabet Inc. Class C Report is another -- is because the fund aims to stay within 3-5% of the S&P 500 and it probably wouldn't be able to do that owning just tobacco, utilities and pharmaceuticals.
The option strategy most resembles what is known as a collar where call options are sold and the proceeds from the sale are then used to buy put options. That can protect against a market decline and provide some additional income above and beyond the dividends, but it can also cap the upside as the portfolio doesn't participate in price appreciation above the strike price of the call option sold.
The portfolio managers have leeway in terms of the call options they choose to sell, whether to include puts at any given time and how much put exposure to have in relation to the number of calls sold. Currently the fund has covered calls that expire in an average of 69 days and are an average of 2.13% out of the money. The puts all expire in March and are 9% out of the money.
The options used will be only S&P 500 options and the options strategy can comprise up to 20% of the fund's net asset value.
The equity portfolio under the hood of FTLB may very well be able to meet the objective of staying within 3-5% of the S&P 500, but the option overlay may make it difficult for FTLB itself to keep that close.
As noted, the current call options -- which cap the upside -- average 2% out of the money and collectively expire in about two months. In the 11 two-month rolling periods of 2013, there were eight instances where the S&P 500's gain exceeded 2%, which means that the fund would have probably left a lot of gains on the table. FTLB will execute its strategy using only S&P 500 index options.
The reason money would have been left of the table is because when an S&P 500 call that has been sold in the way the FTLB does goes in the money, it will either be allowed to settle for cash, which means paying out the difference between the option strike price and the prevailing index price, or will be rolled forward to a new option, both of which would be a hit to the fund's NAV.
FTLB is actively managed, and so it is possible that nimble trading could have avoided the above scenario, but the situation does create context for what the strategy will need to overcome in years like 2013. Any option strategy resembling a collar tends work best when the market is up a little, down a little or down a lot, and the market is less likely to go up a lot after it has just gone up a lot as it did in 2013.
At the time of publication, the author held no positions in any of the funds mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.