Specialized ETFs that generate income from volatility

What do the following have in common?

• People who lose their tempers easily
• Certain chemical compounds
• The stock market

They’re all inherently volatile, prone to sudden change.

The market, a stock or a sector can change direction as quickly as a warming liquid turns into gas and some people become bellicose after one too many drinks.

Physicians learned what not to do in their college chem labs, and they can always skip drinks with intemperate friends. Yet, some may react (or overreact) to market volatility in ways that are harmful to their wealth.

Regarding the stock market, high volatility means that major indices are fluctuating widely and relatively rapidly. While a boon to those who know how to profit from it, this is vexing for most individual investors.

Avoiding damage from volatility is really an exercise in investors’ overcoming their own worst enemy: themselves.

Statistical myth

Many investors believe that most years, the market is more or less normal — that it often reflects its annual long-term average by rising 8% to 12%. This assumes that statistical averages necessarily occur frequently. But on average annual performance is a statistical myth because years with “average” performance are rare. Extremes are shaped by market volatility.

Though the long arc of the market is upward, volatility is widely viewed as a scourge. Legendary investor Warren Buffett maintains that this is irrational. He says that many business schools mislead their students by wrongly teaching that volatility is a negative thing.

Buffett says investors should embrace it as force to be harnessed for gain. But instead, they do risky things, like selling rashly when values are down, when they should probably stay invested and let shares recover; they always do, eventually.

In recent months, the market has at times been a bit more volatile than it was last year, with some intraday spikes in the CBOE Volatility Index (VIX), which measures volatility. VIX levels higher than 30 indicate elevated investor fears and near-term market instability, while levels below 20 suggest a relatively calm market. Thus, the VIX is known by the moniker, the fear index.

In the last week of March, oil prices spiked, and fluctuated with varying White House statements regarding the likely length of the conflict. This goosed the VIX from 11.3 to 30.54, the steepest spike so far this year.

At the root of all this was the closure of the 21-mile-wide Strait of Hormuz, a major corridor for oil tankers. (Despite increasing adoption of clean energy, much of the world still runs largely on fossil fuels.)

Mid-term election years

Even after the war ends and the strait is reopened, which may have happened by the time you read this, volatility will probably remain relatively high until November because 2026 is a midterm election year. In such years, the market has historically seen relatively high VIX levels, yet historically, most have ended with a gain for the S&P 500.

That’s over the long term. Outcomes in the shorter term haven’t been as good. In the six midterm election years this century, the S&P 500 has posted positive returns in three and negative in three.

In early April, it appeared that, contrary to far more sanguine projections earlier this year, the index might end the year with only single-digit gains.

So investors should keep their seat belts buckled and resist the fearful impulse to commit the common blunder of selling low.

Investors who are especially nettled by volatility may need to rearrange some mental furniture to become more comfortable with it. Those who just can’t handle it probably shouldn’t be in the stock market.

Volatility can be leveraged through various trading strategies, some of them quite complex. Yet these strategies and the excellent returns they can generate are available to the average individual through funds whose managers know how to get down into the technical weeds. Annual dividend yields, dividend income relative to share price, is usually substantially higher than those paid by investment-grade bonds — from around 5% to well into double digits.

ETF explosion

A decade ago, there were only a handful of these actively managed funds, but because of the explosion of new exchange-traded funds (ETFs) in recent years, there are now more than 100. Previously available only to the wealthy through specialized advisors, volatility-based ETFs are now widely accessible. Like regular stocks, shares traded on major exchanges can be easily purchased in brokerage accounts.

Some are highly leveraged and involve too much risk for most individual investors, and brokerage account research pages carry stern warnings about potential loss of principle.

But others provide opportunities for substantial income with manageable risk. Here are a few suitable for individual investors:

• First Trust Rising Dividend Income (RDVI). This fund generates income from trading options on an underlying portfolio of dividend-paying stocks, currently from all 11 market sectors. Average annual dividend yield over the last 12 months: nearly 8%.
• JP Morgan Equity Premium Income (JEPI). This fund also generates income from options, using S&P 500 index as its benchmark. Annual dividend yield: about 8%.
• JP Morgan Nasdaq Equity Premium (JEPQ). Using options with exposure to the Nasdaq 100 (large tech) index, along with equity-linked notes, these ETFs are a combination of fixed-income (bond or bond-like investments) and the performance of the Nasdaq 100 index (large tech stocks). Annual dividend yield: about 10%.
• Calamos Autocallable Income (CAIE). This new ETF generates superior income using a laddered (overlapping) portfolio of autocallable notes, a somewhat esoteric investment that’s described by Investopedia as being “part bond and part a bet on [the direction of] the stock market.” These notes, representing loans from investors, are linked to the performance of S&P 500.

Individually, autocallables carry substantial risk because market performance over set periods is of course uncertain. But if one note goes south, this loss is averaged into the performance of the laddered portfolio, significantly reducing risk. Annual dividend yield: about 15%.

• Calamos Nasdaq Autocallable Income (CAIQ). Uses the same basic strategy as CAIE, but in this fund, the notes are linked with an index of stocks from the Nasdaq 100. So the same market caveat applies, relative to the Nasdaq 100.

Annual dividend yield: a whopping 19% —better than stock market returns in many good years.

Typically, such funds state capital appreciation as a secondary goal, but the compelling reason to own them is to collect income.

They can be a highly desirable perennial holding for retirees looking to generate additional monthly income to pay regular living expenses, especially when held in a Roth IRA (where gains are tax free because all money invested is post-tax). They also make sense for many investors who are still working, as extra income comes in handy for meeting unexpected needs, And this way, they don’t have to sell shares of regular stock to raise cash.

Due diligence should include research into the dividend history to determine a fund’s record of payouts after steep share price declines. All of these funds tend to cut dividends in times of trouble, but the desirable ones tend to restore earlier, higher dividend levels after the market recovers.

Dave Sheaff Gilreath, CFP,® is a Partner Advisor Allworth Financial LP, an investment advisory firm registered with the SEC. Investments mentioned in this article may be held by Allworth Financial, affiliates or related persons.

.