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In the ever-evolving landscape of investment strategies, options-based exchange traded funds (ETFs) have emerged as a compelling choice for investors seeking to refine their risk and reward profile. While these innovative vehicles may provide unique opportunities for enhanced income generation or risk management, they are often viewed as complex and opaque by both advisors and their clients. Let’s dig into their structure, investment objectives, and the market conditions contributing to their rising popularity.

Options-based ETFs are designed to cater to a range of investor objectives, primarily falling into three categories:

Protection, Income, or Growth. Most recent flows in this space have been concentrated in the protection and income categories.

Protection ETFs, including hedged equity and buffered strategies, aim to reduce downside risk in equity portfolios, smoothing returns and providing a measure of capital preservation during market drawdowns while allowing some level of upside participation. This approach may be appealing to investors concerned about potential equity market drawdowns or for those sitting on cash and looking to add equity exposure with built-in downside protection.

Income ETFs focus on generating enhanced cash flows through option-writing strategies such as covered calls. These strategies forego some of the potential upside in the underlying equity portfolio in exchange for regular distributable income, typically in the range of 5% to 10% per year1.

This approach may be appealing to investors seeking steady income. These strategies may offer an income stream that is potentially more tax efficient than traditional fixed income investments while also being less sensitive to the level or direction of interest rates.

The market demand for options-based ETFs has surged in the past several years, potentially fueled by three primary drivers. First, elevated market uncertainty and equity valuations create heightened concerns about downside risk, prompting investors to seek strategies that provide a buffer against losses. Second, an extended period of muted fixed income yields created a strong demand for consistent yield and for strategies offering regular enhanced cash flows. Third, investors increasingly seek greater customization in their risk/return profile beyond what is available from traditional stock or bond investments.

Options-based ETFs may allow for more nuanced positioning, dialing back volatility or trading some potential upside for regular income, making them a more flexible tool for tailoring portfolios to specific objectives and risk tolerances.

Bottom Line: Options-based ETFs may present a valuable opportunity for investors seeking to enhance their portfolios with sophisticated risk management, enhanced income generation and tax efficiency, particularly in a complex financial landscape like the current environment.

For more information on Parametric Equity Premium Income ETF (PAPI) click here and for more information on the Parametric Hedged Equity ETF (PHEQ) click here.

1Based on the competitor ETFs in the “Derivative Income” category on Morningstar. Average Trailing 12-Month Yield is 8.2% with Median at 7.67%, both within the range of 5% to 10%.

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Risk Considerations
This material is a general communication, which is not impartial, and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision. The indexes do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto. 1,600+ custom options portfolios managed can lose money investing in this fund.

There is no assurance that a fund will achieve its investment objective. Funds are subject to market risk, which is the possibility that the market values of securities owned by the fund will decline. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Options are not suitable for all investors and carry additional risks. Options may be illiquid, and the funds may have difficulty closing out its position. A decision as to whether, when and how to use options involves the exercise of skill and judgment and even a well-conceived option   transaction may be unsuccessful because of market behavior or unexpected events. The prices of options can be highly volatile and the use of options can lower total returns.

The views and opinions and/or analysis expressed are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time without notice due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively the Firm”) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.
This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and the Firm has not sought to independently verify information taken from public and third-party sources.