The S&P 500 is reaching new highs, inflation appears to be under control and there may even be a rate cut on the horizon. On the other hand, stock valuations seem stretched, the job market is flashing warning signs, election season is in full swing and wars continue to rage across the Middle East and Europe.
If you’re an investor, you might be wondering whether you should be buying or selling in these market conditions. But fortunately, there’s another option — hedged buying!
Let’s look at why you might want to consider collar ETFs.
Understanding Collar ETFs
The “collar ETF” is an options strategy that provides a balance between market participation and risk management. Using options, they restrict performance to a specific range through the option’s expiration date, adding stability in turbulent times.
The collar strategy has three parts:
- Long Position – The fund owns a long position in the underlying index. For example, the XCLR tracks the S&P 500 and the QCLR tracks the Nasdaq 100.
- Protective Puts – The fund purchases a put option on the index with a strike price that’s typically 5% below the current index level. This provides downside protection if the market falls by creating a price floor (maximum loss).
- Covered Calls – The fund sells call options on the index with a strike price that’s usually 10% above the current index level. The income from selling the option offsets the cost of the protective put, but caps maximum the upside.
How Collar’s Work – Source: GlobalX
With collar ETFs, you can implement this complex strategy in a convenient, packaged form. The funds typically use swap agreements to replicate the performance of an underlying index and then buy 3-month put options and sell 3-month call options. And, every quarter, they automatically rebalance to maintain the 95-110 collar range.
Popular Collar ETFs
Here are some collar ETFs, including actively managed, which are sorted by their YTD total return and range from 13.4% to 18.5%. They have AUM between $2.5M and $682M and expenses between 0.25% and 0.79%. They are currently yielding between 0.5% and 1%.
| Name | Ticker | Type | Actively Managed? | AUM | YTD Total Ret (%) | Yield | Expense |
|---|---|---|---|---|---|---|---|
| Aptus Collared Investment Opportunity ETF | ACIO | ETF | Yes | $682M | 18.5% | 0.5% | 0.79% |
| Global X S&P 500 Collar 95-110 ETF | XCLR | ETF | No | $2.6M | 16.6% | 1% | 0.25% |
| Global X NASDAQ 100 Collar 95-110 ETF | QCLR | ETF | No | $2.52M | 13.4% | 0.6% | 0.26% |
Why Buy Collar ETFs Today?
The S&P 500 is near record highs, but valuations seem stretched. Inflation seems under control, but the economy is on thin ice. And while global wars have been contained thus far, there’s no guarantee the conflicts won’t spread over the coming year. In this environment, it’s easy to see why investors may want to hedge their bets.
The S&P 500’s Shiller P/E ratio is near record highs. Source: Multpl.com
The beauty of collar ETFs is their balanced approach. By holding long stock positions, investors can participate in the market’s upside potential. But, at the same time, protective puts create a safety net that limits potential losses during a sudden downturn. That way, you don’t have to attempt to follow and time the market.
The strategy may be especially appealing to those in or nearing retirement. In many cases, these individuals may be happy to sacrifice some upside potential to eliminate the possibility of a catastrophic decline in their equity portfolio. But rather than selling into cash, they can still realize potential upside and keep up with inflation.
Considerations and Trade-Offs
Most investors know the market saying, “There is no free lunch.” In other words, no strategy gives you the best of all worlds — and collar ETFs are no exception.
Collar ETFs involve trading off upside potential for downside protection.
Younger investors with a long-time horizon may find the trade-off unacceptable. Between 2015 and 2022, the S&P 500 exceeded a 10% return five times but only fell more than 5% once in 2022. As a result, those investors who use collar ETFs could have missed out on substantial gains in 2017, 2019, 2020 and 2021 — and the future compounding of those gains!
Collar ETFs also come with more expenses than passive index funds. For instance, the Nasdaq 100 Collar 95-110 ETF (QCLR) has a 0.26% expense ratio. While that’s far lower than many mutual funds, it’s much higher than the sub-0.1% expense ratios that passive index ETFs offer — and those costs eat into potential returns.
The Bottom Line
Collar ETFs may be worth a second look during today’s market with its high valuations, mixed economic signals and geopolitical uncertainty. They offer a way to stay in the market while providing a measure of downside protection.
However, as with any investment strategy, it’s crucial to consider your individual risk tolerance, investment goals and overall financial situation. Consulting with a financial advisor can help determine if collar ETFs are the right fit for your portfolio.