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👉 Small Caps + Monthly Income

An interesting strategy with a 14%+ annual yield.

Hi everyone — Austin Hankwitz here.

As you might know, we’re always looking for well-written content and analysis to share with our subscribers. A few months ago I stumbled upon Nicholas Bratto on Seeking Alpha and we quickly became friends.

Nicholas does a wonderful job of analyzing ETFs and single stocks in a very approachable, easy-to-understand manner. The following content is a “repost” of his analysis on the NEOS Russell 2000 High Income ETF, IWMI.

Small cap companies are usually the biggest benefactors of lower tax rates, and considering the “Red Wave” that just swept through the United States it’s safe to assume lower corporate tax rates are around the corner.

Enjoy this well-written analysis by Nicholas Bratto, and if you know of other analysts online that publish great work — never hesitate to send them our way :)

IWMI: Generating Income with Lower Volatility in a Shifting Small-Cap Market

Summary

  • IWMI ETF combines small-cap stock exposure with an active options strategy, offering tax-efficient monthly income yielding 14.82%.

  • Small-cap stocks are poised for a comeback: IWMI positions itself to capitalize on potential shifts in market leadership as macroeconomic factors favor value-oriented, smaller companies.

  • IWMI aims to enhance risk-adjusted returns, providing a strategic income option for investors seeking stability and upside potential with less volatility.

Over the summer, NEOS launched the NEOS Russell 2000 High Income ETF using the same option overlay strategy on US small-cap stocks: the Russell 2000 Index.

Given the continued positive performance of SPYI and QQQI, I believe IWMI can offer a similar level of risk-adjusted performance, gaining exposure to small-cap stocks while hedging volatility with an options overlay income strategy.

IWMI Summary

IWMI is an actively managed ETF which seeks high, tax efficient monthly income, with the opportunity to capture upside when the underlying index, the Russell 2000, rises.

Incepted June 25th, 2024 the fund currently has $79M AUM with a distribution rate of 14.82%. IWMI is ran effectively the same as SPYI and QQQI. I encourage readers not familiar with the mechanics of these funds to read my NEOS articles which go into detail about how these funds are managed and operated.

To summarize, IWMI generates income by selling Russell 2000 ("RUT") index options and buying call options for upside capture when the Russell 2000 rises. These options would presumably be bought when volatility or the RVX index is low, similar to the strategy SPYI and QQQI execute for the VIX and VXN respectively, but I couldn't find this exact information stated in the prospectus.

IWMI uses the same layers of tax efficiency utilized by SPYI and QQQI as well:

  • The contracts sold are taxed 60%/40% long/short-term capital gains tax rates respectively per Section 1256 contracts.

  • Part of the fund earns qualified dividends from the equities held.

  • Utilization of tax-loss harvesting.

  • Uses Return of Capital (ROC) classification on the distributions, which makes > 90% of the distributions deferred long-term capital gains.

Below is the performance of IWMI since inception compare to iShares Russell 2000 ETF (IWM), but since the fund has only been around for about 4 months, I defer to draw major conclusions until more time has passed.

Still, one characteristic we can and should see with options-based income ETFs are less volatility than their underlying index. In August, IWM had a drawdown of nearly 10% while IWMI saw a drawdown of about 5% or about half as much.

We can also see a higher Sharpe Ratio during this period of 1.97 for IWMI vs. 1.46 for IWM, suggesting higher risk-adjusted returns.

More time is needed to be sure, but I want to point out to investors the purpose of these funds are not to beat their underlying indices every year in terms of total return, rather it's to offer higher risk-adjusted returns with tax-efficient monthly income. Risk metrics are key to tracking the performance of these funds.

Benchmarking Performance — RYLD vs. VTWO

There's no products quite like the NEOS ETFs let alone with enough history as one like IWMI, however one such similar and popular ETF is Global X Russell 2000 Covered Call ETF (RYLD) with $1.41B AUM. I published an article on RYLD last September and decided to sell my shares shortly after running what my real returns were from my analysis: negative when accounting for inflation. The fund uses a passive at-the-money covered call strategy, so a different strategy than IWMI which uses an out-of-the money call overlay strategy, but the returns of RYLD haven't been good.

RYLD vs. VTWO Total Return (Seeking Alpha)

Comparing to Vanguard Russell 2000 Index Fund ETF Shares (VTWO), VTWO has returned 54.59% vs. RYLDs 23.26% since inception. Even on a risk-adjusted return basis, RYLD has a lower Sharpe Ratio of 0.09 vs. 0.33 for VTWO. To be fair, small-cap stocks in general have not performed well in the last 5 years or even the last decade when compared to the large-cap S&P 500. RYLD actually returned similarly to the Russell 2000 up until about a year ago when small-caps had a small breakout, leaving RYLD behind while the index rose.

This is one of the major issues with passive-options strategies on funds like RYLD: they cannot capture any upside and participate in all the downside, with no active management intervention. I believe IWMI helps solve this problem with their active management strategy.

Small-Cap Reversal

There has been much discussion the past few years in the investment community speculating a small-cap reversal is inbound to overtake large-cap stocks. There's a great white paper on small-cap stocks by WisdomTree reminding investors of the value and performance that can be unlocked with small-cap stocks. A small-cap reversal may make sense when we account for the dominance of large-cap growth stocks being driven by historically low interest rates, low inflation, and low-stable economic growth, which were further amplified by the COVID-19 pandemic.

These factors are unlikely to continue as elevated interest rates, higher inflation, and more volatile economic growth tend to create a more favorable environment for small-cap value stocks to outperform and carry the index. Historically, market leadership between large and small-caps tends to shift in cycles over about 10 years. With large-caps outperforming since 2014 and small-cap value already outperforming since late 2020, the current environment suggests a reversal may be underway. Interestingly, small-caps have outperformed large caps by 386% cumulatively since 1926, making this shift in leadership historically consistent.

Small Caps vs. Large Caps: Cumulative Relative Total Returns (WisdomTree)

I published an article on VB covering dividends place in the small-cap stock market and published an article coming full circle on this topic back in August on my Substack showing when adjusted for risk the last 20 years, the small-cap Russell 2000 and large-cap S&P 500 performed almost the same, both returning around 11.20% annually. All in all, while small-caps have underperformed in recent history, the data shows this trend is not unusual and small-caps can offer significant alpha in the market.

Periodic Table of Investment Returns (Bratto Biz Substack, Callan Institute)

Risk Analysis

Regardless of your conviction in the thesis laid out above, small-cap stocks have higher volatility than large-cap making IWMI a good hedge for investors to manage risk by reducing portfolio volatility and generating income, especially during down cycles like small-caps have been experiencing. And remember, IWMI can increase in value another way: by entering into call options spreads to capture upside when a small-cap reversal does happen and the Russell 2000 rises.

As there is not enough data for IWMI, I compared SPYI and the S&P 500 as a surrogate to get an idea of what could be possible with this strategy for the small-cap version.

Although SPDR S&P 500 ETF Trust (SPY) has outperformed SPYI with 28% vs. 20% CAGR since SPYIs inception in January 2023, SPYI has better risk-adjusted returns looking at both the unsystematic and systemic risk profiles.

The beta of SPYI is markedly lower as well at 0.59. Although the Sharpe and Treynor ratios are only slightly higher, I believe with more time and market conditions this gap will widen. These are critical metrics to monitor on IWMI as well as the fund performance unfolds.

Outlook

So, what's my move? My followers across social media know I've been on a relentless pursuit to achieve financial security with my dividend portfolio in my taxable brokerage account. I am enticed by the idea of having at least enough shares of income ETFs like the NEOS funds and other income funds to cover my fixed expenses: subscriptions, cellphone, water, internet, gas, energy, car & home insurance, CapEx, property taxes, and grocery bills.

These are expenses that are never going away and are necessary to survive. The tax efficiency of the distributions, effectively deferred long-term capital gains, is a big driving factor too as this strategy requires significant investment in a taxable brokerage account. I estimate I need about $3000/month or $250,000 invested in funds like SPYI QQQI and IWMI to cover my fixed expenses, with the rest of my money in dividend growth ETFs.

I really like the three funds: SPYI QQQI and IWMI below $50/share or at a discount to the NAV. While I want the funds to dip below $50/share to initiate my equal-weighted positions, I'm also happy if they don't dip below $50/share ever again and continue to slowly appreciate in price.

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