Morningstar - Q2 2024 - 10

Dispatches
Supporters of derivative-income funds can
offer two additional defenses. One, the category's
largest fund, JEPI, has recorded a higher
Sharpe ratio since its May 2020 inception than
the above rivals. True, but because that
outperformance occurred solely during the fund's
first 18 months, with nearly all the fund's
assets arriving afterward, the achievement was
largely theoretical.
The Bull-Market Rebuttal
The other rebuttal is that derivative-income funds
perform best in choppy markets rather than
ones boasting a double-digit annualized gain. This
EXHIBIT 1
Derivative-Income Funds Lag Traditional Rivals
Annualized 5-Year Total Returns
5-Year Return %
Vanguard Dividend Appreciation ETF
Vanguard Dividend Growth
Fidelity Equity-Income
Vanguard Equity-Income
Fidelity Equity Dividend Income
Derivative-Income Funds
Schwab Dividend Equity
Vanguard Dividend Appreciation ETF
Vanguard Dividend Growth
Fidelity Equity-Income
Vanguard Equity-Income
Fidelity Equity Dividend Income
Derivative-Income Funds
Schwab Dividend Equity
Vanguard Dividend Growth
Vanguard Dividend Appreciation ETF
Fidelity Equity-Income
Vanguard Equity-Income
Derivative-Income Funds
Fidelity Equity Dividend Income
Schwab Dividend Equity
EXHIBIT 2
... Even on a Risk-Adjusted Basis
Annualized 5-Year Sharpe Ratios
Vanguard Dividend Growth
Vanguard Dividend Appreciation ETF
Fidelity Equity-Income
Vanguard Equity-Income
Derivative-Income Funds
Fidelity Equity Dividend Income
Schwab Dividend Equity
Source:
3
Sharpe Ratio
6
Source: Morningstar Direct. Data from Jan. 1, 2019, through Dec. 31, 2023.
Sharpe Ratio
8.94
9
0.66
0.63
0.60
0.59
0.2
0.45
0.4
0.63
0.60
0.59
ce: Morningstar Direct. Data from Jan. 1, 2019, through Dec. 31, 2023.
0.2
0.45
0.4
0.6
0.8
1.0
0.66
0.6
0.77
0.76
0.8
1.0
10.19
0.77
0.76
12
15
13.84
13.50
12.27
5-Year Return %
10.19
8.94
3
6
9
12.27
11.85
11.83
12
15
11.85
11.83
13.84
13.50
Further muddying the waters is that, for
derivative-income funds, the pattern of stock
market returns is as important as the
level. The more volatile security prices are, the
more valuable call (or put) options become.
Because derivative-income funds sell options,
that bromide works in reverse for them.
They struggle when market volatility increases
and profit when it subsides.
Case Study Number One: the Mid-1980s
An example of the former occurred during the
mid-1980s. At that time, funds that wrote
covered calls did so mostly with bonds, as opposed
to equities. But the same principles applied.
If bond prices moved sharply in one direction
and then the other, those funds could become
two-time losers. They would suffer once
when rising bond prices forced them to surrender
their winners and then again when they
held their entire portfolio through the bond
market's decline.
That is exactly what happened. From 1986 through
1987, 10-year Treasury yields went nowhere.
They exited the 24-month period at virtually the
same amount at which they had entered it.
Unfortunately for those option-selling bond funds,
those endpoints were deceiving. Treasury
bonds initially rallied for 14 months, during which
10
Morningstar Q2 2024
claim, which concerns not only derivative-income
funds but also other high-distributing strategies,
cannot be so easily dismissed. Because
derivative-income funds concede capital growth,
their worst relative performance occurs during
bull markets.
In theory, that is correct. As with other stock
funds, the highest relative gains for derivativeincome
funds come when stock prices
increase. But because derivative-income funds
sign away some of their potential capital
growth, they will likely trail traditional equity funds
during such times.
In contrast, if stocks are languishing, derivativeincome
funds may well receive something for
nothing. After all, they are paid to surrender their
upside. If there is no upside, then derivativeincome
funds enjoy a free investment lunch. They
eat the money they collected from selling call
options (or the interest paid by their equity-linked
notes) while ceding nothing in return.
That argument makes sense. However, it
assumes a streamlined model, where equities
in unison either rise, stagnate, or fall. In
practice, though, fund portfolios usually do all
three. That is, even if the overall stock
market is moping, many derivative-income
fund positions will be increasing-and
thus potentially called away. Similarly, during
bull markets, some of the funds' holdings
will trail the averages, thereby preventing the
call option from being exercised.
Morningstar - Q2 2024

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