Jun
21
2023
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How to Find the Right Fixed Index Annuity Rate for Your Needs

By | Growing Wealth, invest, Investing | Comments Off on How to Find the Right Fixed Index Annuity Rate for Your Needs

Annuities are a type of insurance contract that investors can use to fund their retirement or meet other financial goals. When someone purchases an annuity, they pay premiums to the annuity issuer. The annuity company then makes payments back to the annuitant as agreed in the annuity contract.

Those payments can start almost immediately or be deferred to a future date. Payments can be made monthly, annually, or in a single lump-sum. Earnings from the annuity are typically tax-deferred and withdrawals are taxable as ordinary income.

Generally, annuities are indexed, fixed, or variable. With a fixed annuity, you’re guaranteed to earn a minimum rate of return, making them relatively safe investments. Variable annuity returns hinge on how underlying annuity investments, such as mutual funds, perform which can make them riskier. Indexed annuities strike a middle ground in terms of their risk/reward profile.

Annuities can provide a steady stream of income in retirement, something that might feature in many people’s investment goals. What’s important to keep in mind, however, is that rates of return generated can vary from one annuity to the next. It’s helpful to understand how to compare index annuity rates side by side to find the best one for your needs.

What Is an Indexed Annuity?

An indexed annuity, or fixed index annuity, is a specific type of annuity product that can yield a minimum guaranteed rate of return along with a rate of return that’s linked to a stock market index. For example, the annuity’s performance may be based on the performance of the S&P 500 Composite Price Index. This is a market capitalization-weighted index that represents 500 of the largest publicly traded U.S. companies.

This type of annuity may be suitable to investors who seek upside potential with built-in downside protection, while enjoying the benefits of tax-deferred growth. Indexed annuities may also be favorable among investors who lean toward a passive versus active investing strategy.

What Are Fixed Index Annuity Rates?

Fixed index annuity rates are the guaranteed minimum rate of return on an annuity. Rather than tracking with interest rates, the fixed index annuity rate is benchmarked against a particular index.

How Fixed Indexed Annuities Work

Fixed index annuities have two phases: the accumulation phase and the income phase.

Once you purchase a fixed indexed annuity, the accumulation phase begins. This is the period during which your annuity earns interest on a tax-deferred basis. The amount of money you have in the annuity, also referred to as the contract value, can fluctuate over time based on how the underlying index that the annuity tracks is performing.

Annuity returns are typically recalculated every 12 months, though the annuity contract should spell out how and when return calculations occur. It’s important to keep in mind that the contract may specify a cap rate, which represents the maximum positive rate of return an indexed annuity can earn.

The income or annuity phase is when payments are made back to you from the contract. These payments can be made periodically or be delivered in a single lump sum. Additionally, they can last for a specified time frame or for the duration of your natural life. If you’re married, indexed annuity payments can also continue to be paid to your spouse after you pass away. The annuity contract will detail the payment schedule.

For example, in the accumulation phase, an annuity might pay out a minimum of 3% with a 7% rate cap (even if the index is tracking at 11%). In the income phase, the fixed index annuity might be paid monthly starting at a predetermined date, and pay out across the lifetime of you and/or your spouse.

How Are Fixed Index Annuity Rates Set?

Broadly speaking, index annuity rates are tied to the index they track. So again, this could be an index like the S&P 500 Composite Price Index or the Nasdaq 100.

With a fixed index annuity, the annuity company guarantees a minimum interest rate alongside the interest rate generated by the underlying index.

When setting fixed index annuity rates, annuity contract providers typically use several factors to determine how much of a return is credited to the contract owner. The actual rate of return realized from an indexed annuity can depend on:

•  Cap rate
•  Participation rate
•  Margin/spread fees
•  Riders

Here’s more on how each one affects fixed index annuity rates.

Cap Rate

Cap rate represents the upper limit on returns that an annuity can earn over time. So for instance, an indexed annuity that has a 3.5% cap rate would limit the returns credited to the annuity owner to that amount—even when the underlying index produces a higher rate of return. Generally, cap rates fall somewhere between 3 and 7% per year.

Participation Rate

If the index an annuity tracks goes up, the participation rate determines how much of that gain is credited to an annuity owner. For instance, if the index increases by 10% and the participation rate is 80%, an 8% return would be credited.

Margin/Spread Fees

Also referred to as an administrative fee, this fee can deduct a set percentage from index gains. An indexed annuity that realizes a 10% gain and has a 3% spread fee, for example, would yield a net credited return of 7%.

Riders

Riders can be used to enhance fixed indexed annuity benefits. For instance, you might choose to add a rider that would guarantee lifetime income payments to your spouse if you’re married. Expanding the annuity’s coverage can result in added premium costs, which may reduce credited returns.

What Is a Good Fixed Index Annuity Rate?

A “good” fixed index annuity rate is one that results in a rate of return that aligns with your objectives and needs. Index annuity rates can also vary based on the length of the contract term. Cost is also an important consideration, as indexed annuities can charge a variety of fees, including administrative fees and surrender charges, which may apply if you decide to cancel an annuity contract.

The top index annuities are the ones that offer the best combination of high rates and low fees. It’s also important to consider an annuity company’s ratings before purchasing an indexed annuity. Annuity Advantage can offer insight into how financially healthy an annuity provider is and how likely they are to be able to make annuity payments back to you when the time comes.

Is an Indexed Annuity Right for You?

Fixed index annuities can offer the potential to earn higher rates of return compared to traditional fixed annuities. At the same time, they may be less risky than a variable annuity product since they track an index rather than investing in the market directly.

Investment risk management is an important part of any strategy for growing wealth, even when you’re starting from scratch with building an investment portfolio. Indexed annuities aim to help with balancing that risk while creating an ongoing stream of income to rely on in retirement.

That said, it’s also important to consider how fixed index annuity rates compare to the rate of return one could earn by investing in the market directly. For example, you may see better returns by investing in individual stocks. That does involve taking more risk but individuals with a longer timeline until retirement generally have a broader window to recover from market downturns.

The Takeaway

A fixed index annuity offers investors a minimum guaranteed rate of return along with a rate of return that’s linked to a stock market index. While fixed indexed annuities do offer some advantages, they may not suit every investor and it’s important to research index annuity rates to find the right one.

If you’re in the early stages of building a portfolio, SoFi Invest is a great place to start. Whether you want to begin investing in ETFs or stocks, or you prefer hands-on investing or an automated approach, SoFi Invest can help.

Find out how to invest with SoFi.


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Jun
21
2023
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Are Fractional Shares Worth Buying?

By | Growing Wealth, invest, Investing | Comments Off on Are Fractional Shares Worth Buying?

Fractional shares are a useful way to allow new investors to get their feet wet by investing small amounts of money into parts of a share of stock. For some investors, fractional shares are worth it because it means they can own a part of a stock from a company they are interested in, without committing to buying a whole share.

While fractional shares have much in common with whole shares, they don’t trade on the open market as a standalone product. Because of that, fractional shares must be sold through a major brokerage.

Recommended: How to Open a Brokerage Account

What Does It Mean to Buy Fractional Shares?

A fractional share is less than one whole equity share (e.g. 0.34 shares). Fractional shares appreciate or depreciate at the same rate as whole shares, and distribute dividends at the same yield proportionate to the fractional amount.

Fractional shares were previously only available to institutional investors at one-sixteenth intervals, but have recently become widely available to retail investors at exact decimals (in order to increase market pricing precision and lower trading costs).

This new capability offers another layer of financial inclusion to casual investors by lowering minimum investing requirements to thousands of stocks and assets and making them available in smaller quantities. According to Gallup, 45% of all Americans have no stock investments—but fractional shares provide an increasingly lower barrier to investing than in previous generations.

Why Fractional Shares Are Worth Buying

For some investors, these positives make buying fractional shares worth it.

Access to Unaffordable Stocks

Fractional shares can help build a portfolio made of select stocks, some of which may be too expensive for some investors to afford one whole share. With fractional shares, an investor can choose stocks based on more than just price per share.

Previously, new investors would face price discrimination for not having enough funds to buy one whole share. But with fractional shares, an investor with $1,000 to spend who wants to buy a stock that costs $2,000 per share, can buy 0.5 shares of that stock.

Fractional shares make it easier to spread a modest investment amount across a variety of stocks. Over time, it may be possible to buy more of each stock to total one or more whole shares. In the meantime, buying a fractional share allows an investor to immediately benefit from a stock’s gain, begin the countdown to qualify for long-term capital gains (if applicable), and receive dividends.

A Doorway to Investing

History has shown that the stock market typically outperforms fixed-income assets and interest-bearing savings accounts by a wide margin. If equities continue to provide returns comparable to the long-term average of 7%, even a small investment can outperform money market savings accounts, which typically yield 1-2%. (Though as always, it’s important to remember that past performance does not guarantee future success.)

By utilizing fractional shares, beginners can make small investments in the stock market with significantly more growth potential even with average market returns versus savings accounts that typically don’t even match inflation.

Maximized Dollar-Cost Averaging

Fractional shares help maximize dollar-cost averaging, in which investors invest a fixed amount of money at regular intervals.

Because stock shares trade at precise amounts down to the second decimal, it’s rare for flat investment amounts to buy perfectly-even amounts of shares. With fractional shares, the full investment amount can be invested down to the last cent.

For example, if an investor contributes $500 monthly to a mutual fund with shares each worth $30, they would receive 16.66 shares. This process then repeats next month and the same investment amount is used to purchase the maximum number of shares, with both new and old fractional shares pooled together to form a whole share whenever possible.

Maximized Dividend Reinvestment Plans

This same scenario applies to dividend reinvestment plans (also known as DRIP investing). In smaller dividend investment accounts, initial dividends received may be too small to afford one whole share. With fractional shares, the marginal dividend amount can be reinvested no matter how small the amount.

Fractional shares can be an important component in a dividend reinvestment strategy because of the power of compounding interest. If an investor automatically invests $500 per month at $30 per share but can’t buy fractional shares, only $480 of $500 can be invested that month, forfeiting the opportunity to buy 0.66 shares. While this doesn’t seem like much, not investing that extra $20 every month can diminish both investment gains and dividends over time.

Stock Splits

Stock splits occur when a company reduces its stock price by proportionately issuing more shares to shareholders at a reduced price. This process doesn’t affect the total value of an investment in the stock, but rather how the value is calculated.

For some investors, a stock split may cause a split of existing shares resulting in fractional shares. For example, if an investor owns 11 shares of a company stock worth $30 and that company undergoes a two-for-three stock split, the 15 shares would increase to 22.5 but each share’s price would decrease from $30 to $20. In this scenario, the stock split results in the same total of $450 but generated a fractional share.

Mergers or Acquisitions

If two (or more) companies merge, they often combine stocks using a predetermined ratio that may produce fractional shares. This ratio can be imprecise and generate fractional shares depending on how many shares a shareholder owns. Alternatively, shareholders are sometimes given the option of receiving cash in lieu of fractional shares following an impending stock split, merger, or acquisition.

Too expensive? Not your favorite stocks.

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Disadvantages of Buying Fractional Shares

Fractional shares can be a useful asset if permitted, but depending on where you buy them could have major implications on their value.

Order Type Limitations

Full stock shares are typically enabled for a variety of order types to accommodate different types of trading requests. However, depending on the brokerage, fractional shares can be limited to basic order types such as market buys and sells. This prevents an investor from setting limit orders to trigger at certain price conditions and from executing trades outside of regular market hours.

Transferability

Not all brokerages allow fractional shares to be transferred in or out, making it difficult to consolidate investment accounts without losing the principal investment or market gains from fractional shares. This can also force an investor to hold a position they no longer desire, or sell at an undesirable price to consolidate funds.

Liquidity

If the selling stock doesn’t have much demand in the market, selling fractional shares might take longer than hoped or come at a less advantageous price due to a wider spread. It may also be possible to come across a stock with full shares that are liquid but fractional shares that are not, providing difficulty in executing trades let alone at close to market price.

Commissions

Brokerages that charge trading commissions may charge a flat fee per trade, regardless of share price or quantity of shares traded. This can be disadvantageous for someone who can only afford to buy fractional shares, as they’re being charged the same fee as someone who can buy whole or even multiple shares. Over time, these trading fees can add up and siphon limited capital that could otherwise be used to buy additional fractional shares.

Higher transaction fees

Worse yet, some brokerages may even charge higher transaction fees for processing fractional shares, further increasing investor overhead despite investing smaller amounts.

What Happens to Fractional Shares When You Sell?

As with most brokerages that allow fractional shares, fractional shares can either be sold individually or with other shares of the same asset. Capital gains or losses are then calculated based on the buy and sell prices proportionate to the fractional share.

The Takeaway

Fractional shares are an innovative market concept recently made available to investors. They allow investors of all experience and income levels access to the broader stock market—making it worth buying fractional shares for many investors.

Fractional shares have many other benefits as well—including the potential to maximize both DRIP and dollar-cost averaging. Still, as always, it makes sense to pay attention to downsides as well, such as fees disproportionate to the investment, and order limitations.

For investors who are curious about fractional shares, SoFi Invest® online brokerage makes it easy to start investing in partial stocks with as little as $5.

Find out how to invest in fractional shares with SoFi Invest.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
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Stock Bits
Stock Bits is a brand name of the fractional trading program offered by SoFi Securities LLC. When making a fractional trade, you are granting SoFi Securities discretion to determine the time and price of the trade. Fractional trades will be executed in our next trading window, which may be several hours or days after placing an order. The execution price may be higher or lower than it was at the time the order was placed.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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Jun
21
2023
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What Is a Clearinghouse?

By | invest, Investing | Comments Off on What Is a Clearinghouse?

A clearinghouse is a financial institution that acts as a middleman between buyers and sellers in a market, ensuring that transactions take place even if one side defaults.

If one side of a deal fails, a clearinghouse can step in to fill the gap, thus reducing the risk that a failure will ripple across financial markets. In order to do this, clearinghouses ask their members for “margin”–collateral that is held to keep them safe from their own actions and the actions of other members.

While often described as the “plumbing” behind financial transactions, clearinghouses became high profile after the 2008 financial crisis, when the collapse of Lehman Brothers Holdings Inc. exposed the need for steady intermediaries in many markets.

Regulations introduced by the Dodd-Frank Act demanded greater clearing requirements, turning the handful of clearinghouses in the country into some of the most systemically important entities in today’s financial system.

Here’s a closer look at them.

How Clearinghouses Work

Clearinghouses handle the clearing and settlement for member trades. Clearing is the handling of trades after they’re agreed upon, while settlement is the actual transfer of ownership–delivering an asset to its buyer and the funds to its seller.

Other responsibilities include recording trade data and collecting margin payments. The margin requirements are usually based on formulas that take into account factors like market volatility, the balance of buy-versus-sell orders, as well as value-at-risk, or the risk of losses from investments.

Because they handle investing risk from both parties in a trade, clearinghouses typically have a “waterfall” of potential actions in case a member defaults. Here are the layers of protection a clearinghouse has for such events:

1. Margin requirements by the member itself. If market volatility spikes or trades start to head south, clearinghouses can put in a margin call and demand more money from a member. In most cases, this response tends to cover any losses.
2. The next buffer would be the clearinghouse’s own operator capital.
3. If these aren’t enough to staunch the losses, the clearinghouse could dip into the mutual default fund made up from contributions by members. Such an action however could, in turn, cause the clearinghouse to ask members for more money, in order to replenish the collective fund.
4. Lastly, a resolution could be to try to find more capital from the clearinghouse itself again–such as from a parent company.

Are Clearinghouses Too Big to Fail?

Some industry observers have argued that regulations have made clearinghouses too systemically important, turning them into big concentrations of financial risk themselves.

These critics argue that because of their membership structure, the risk of default in a clearinghouse is spread across a group of market participants. And one weak member could be bad news for everyone, especially if a clearinghouse has to ask for additional money to refill the mutual default fund. Such a move could trigger a cascade of selling across markets as members try to meet the call.

Other critics have said the margin requirements and default funds at clearinghouses are too shallow, raising the risk that clearinghouses burn through their buffers and need to be bailed out by a government entity or go bankrupt–a series of events that could meanwhile throw financial markets into disarray.

Clearinghouses in Stock Trading

Stock investors have already probably learned the difference between a trade versus settlement date. Trades in the stock market aren’t immediate. Known as “T+2,” settlement happens two days after the trade happens, so the money and shares actually change hands two days later.

In the U.S., the Depository Trust & Clearing Corp. handles the majority of clearing and settling in equity trades. Owned by a financial consortium, the DTCC clears on average more than $1 trillion in stock trades each day.

Clearinghouses in Derivatives Trading

Clearinghouses play a much more central and pivotal role in the derivatives market, since with derivatives products are typically leveraged, so money is borrowed in order to make bigger bets. With leverage, the risk among counterparties in trading becomes magnified, increasing the need for an intermediary between buyers and sellers.

Prior to Dodd-Frank, the vast majority of derivatives were traded over the counter. The Act required that the world of derivatives needed to be made safer and required that most contracts be centrally cleared. With U.S. stock options trades, the Options Clearing Corp. is the biggest clearinghouse, while CME Clearing and ICE Clear U.S. are the two largest in other derivatives markets.

The Takeaway

Clearinghouses are financial intermediaries that handle the mechanics behind trades, helping to back and finalize transactions by members.

But since the 2008 financial crisis, the ultimate goal of clearinghouses has been to be a stabilizing force in the marketplace. They sit in between buyers and sellers since it’s hard for one party to know exactly the risk profile and creditworthiness of the other.

For beginner investors, it can be helpful to understand this “plumbing” that allows trades to take place and helps ensure financial markets stay stable.

Want to start investing but don’t know where to start? SoFi Invest® has financial planners ready to answer any questions. Investors can also choose between the Active Investing or Automated Investing platforms, depending on how hands-on or hands-off they want to be.

Check out SoFi Invest today.


SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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Jun
16
2023
What is a Covered Call ETF: Strategies & Benefits

Pros and Cons of a Covered Call ETF — and When to Buy

By | Growing Wealth, Investing | Comments Off on Pros and Cons of a Covered Call ETF — and When to Buy

A covered call ETF is an exchange-traded fund that provides investors with additional income by writing options on the securities the ETF holds. These actively-managed ETFs offer investors the benefits of writing call options on stocks, without them having to participate in the options market directly.

The upside is that investors take on less risk and potentially earn income in the form of options contract premiums on top of dividends. The downside is that potential upside profits will be capped because the call options will have to be exercised once the underlying security reaches a certain strike price (one of many options trading terms to know), at which point the shares will be called away from the shareholder.

Basics of the Covered Call Strategy

Covered calls involve buying shares of a stock and then writing call options contracts on some of those shares. A covered call could also be referred to as “call writing” or “writing a call option” on a security.

Other investors can then purchase the call option contract. They pay a small fee to the call writer, known as a premium, for doing so. The contract gives a buyer of the option the right, but not the obligation, to buy shares at a specific price on or before a specified date.

In the case of call options, when the share price of the underlying security rises above the strike price, an option holder can choose to exercise the option, at which point the stock will be called away from the person who wrote the call option.

The option holder then receives shares at a cost lower than current market value. Their profits will equal the difference between the option strike price and where the stock is currently trading minus the premium paid. The higher the stock price rises before the expiry date, the greater the profit for the person holding the call option.

Because the call option writer receives income on the deal in the form of a premium, they want the stock price to either stay flat, fall, or rise only slightly. If the stock rises beyond the strike price of the option, then they’ll receive the premium, but their shares will be called away. The option writer will have a gain or loss depending on the difference of the exercise price and the purchase price of the stock and the premium received.

On the other hand, if the stock doesn’t reach the strike price of the option, then the writer keeps both the premium and the shares. They’re then free to repeat the process as many times as they wish.


💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

What Is a Covered Call ETF?

A covered call ETF is an actively-managed exchange-traded fund (ETF) that buys a set of stocks and writes call options on them — engaging in the call-writing process as much as possible in order to maximize returns for investors.

By investing in a covered call ETF, investors have the opportunity to benefit from covered calls without directly participating in the options market on their own. The fund takes care of the covered calls for them.

The ETF covered call strategy usually involves writing short-term (under two-month expiry) calls that are out-of-the-money (OTM), meaning the security’s price is below a call option’s strike price. Using shorter-term options allows investors to take advantage of rapid time decay.

Options like these also serve to create a balance between earning high amounts of premium payments while increasing the odds that the contracts will expire OTM (which, for covered call writers, is a positive outcome).

Writing options OTM serves to make sure that investors can benefit from some amount of the upward price potential of the underlying securities.

When to Buy a Covered Call ETF

It may be a good time to buy a covered call ETF when most of the securities held by the ETF are expected to trade sideways or go down slightly for some time. Beyond that, any time is a good time for investors who find the strategy appealing, want to take the chance of gaining extra income for their portfolios, and don’t mind missing out on outsized gains if the market rips higher.

Covered call ETFs might also be attractive to people nearing retirement, people who are generally more risk-averse, or anyone looking to add some additional income to their portfolio without having to learn how to write and trade options.

If an investor were considering ETFs vs. index funds, they might choose an ETF for the reason that the fund might employ creative strategies like covered calls, whereas index funds merely try to track an index.

When Not to Buy a Covered Call ETF

The one time when it may be advisable not to buy a covered call ETF might be when stocks are generally rising and making new record highs on a regular basis. This is a scenario where covered call ETFs would underperform the rest of the market.

If the underlying securities rise only slightly, and do not exceed the strike prices set for the covered calls, then these ETFs should also perform well. It’s only when stocks rise to the point that the shares get called away from the fund that the fund will almost certainly underperform compared to holding shares directly.

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Pros and Cons of a Covered Call ETF

The main benefits that come from taking advantage of an ETF covered call strategy are reduced risk and increased income.

Pros of a Covered Call ETF

Overall, a covered call ETF has largely the same risk profile as holding the underlying securities would. But some investors see these ETFs as less risky than holding individual stocks because the ETF should, in theory, do as well or slightly better than the market in most situations. (The one exception would be during extended, strong bull markets.)

But while covered call ETFs reduce the risk associated with owning a lot of shares while also providing additional income, hedging against downside risk would best be accomplished by using put options.

Cons of a Covered Call ETF

Covered call ETFs are actively managed, which means they tend to have higher expense ratios than passively managed ETFs that track an index. But the extra income may potentially offset that cost.

The Takeaway

A covered call ETF is an actively managed exchange-traded fund that offers investors the benefits of writing call options on stocks, without them having to participate directly in the options market. For investors looking for a simpler approach, this may be beneficial. Covered call ETFs also have two primary benefits in reduced risk and increased income.

That’s not to say that they don’t have downsides, too. Notably, they tend to be actively-managed, which generally means they have higher associated fees. Again, all of this should be taken into consideration before folding any type of security into an investment strategy.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Jun
16
2023
Tail Risk Explained: Woman investing on phone

Tail Risk, Fat Tails, and What They Mean for Investors

By | Growing Wealth, invest, Investing | Comments Off on Tail Risk, Fat Tails, and What They Mean for Investors

Tail risk is the danger of large investment gains or losses because of sudden and unforeseen events. The term “tail risk” refers to the tails on a bell curve: While the fat middle of the bell curve represents the most probable returns, the tails — both positive and negative — represents the least likely outcomes.

When looking at the bell curve that gives the phenomenon its name, investors sometimes also refer to tail risk as “left-tail risk,” as it refers to the very unlikely and very negative outcomes on the curve.

What Is Tail Risk?

Tail risk is defined by a concept called standard deviation. As a metric, standard deviation shows how widely the price of an asset fluctuates above and below its average. For a volatile stock, the standard deviation will be high, while the standard deviation for a stock with a steady value will be low.

Standard deviation is an important number that investors use to understand how historically volatile a stock is, as well as the level of volatility they can project for it in the future. That projection is based on the underlying assumption that the price changes of a stock will follow the pattern of what’s called normal distribution.

Normal distribution is a statistical term used to describe the probability of an event, and it shapes the bell curve. If you flip a coin 10,000 times, how often will it land on heads or tails? Each time, there is a 50% probability it will land on heads or tails, and the curve describes the likelihood that those 10,000 flips will come out 50/50. The fat middle of the curve says it will be close to 50/50, but there are extremely low probabilities at the low (or skinny) ends of the bell curve that it could be more like 80/20 heads or 80/20 tails.

That approach to probability predicts that a stock selling at a mean price of $45 with a $5 standard deviation is 95% certain to sell between $35 and $55 at the close of that day’s market.

“Tail risk” is used to describe the risk that an investment will fall or rise by more than three standard deviations from its mean price. To continue the example, the hypothetical stock $45 stock has entered the domain of tail risk if, at the end of the trading day, it is priced at $30 or below, or at $60 or above.


💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

What are Fat Tail Risks?

Unpredictable events are ironically predictable, and happen in the markets on a regular basis. And those markets, such as the one following the onset of the pandemic in early 2020, exhibit much “fatter” tails. Another period characterized by having an extremely fat tail was the 2008 Financial Crisis.

They’re called “fat tails” because the outcomes that had been on the extremes were suddenly happening, instead of the ones previously considered probable. This condition is also called by the mathematical term leptokurtosis. As a general rule, because they deviate so wildly from the expected norm, fat tail events present great risk as well as great opportunities for investors.

Tail Risk Strategy

Financial models such as Harry Markowitz’s modern portfolio theory (MPT) or the Black-Scholes Merton option pricing model, employ the assumption that the returns of a given asset will remain between the mean and three standard deviations.

The assumptions made in these long-term market projections can help with planning. But they’re not realistic about how investors receive their market returns over the long term. Rather, the bulk of their returns, no matter how diversified their portfolio, are largely the result of positive tail events. The power of tail events over long periods is one reason that experts tell investors to stay in the markets during fat-tail periods of volatility, even if it is stressful at the time.

Why Investors Hedge Tail Risks

Left-tail events also have the potential to have an extremely negative impact on portfolios. That’s why many investors hedge their portfolios against these events — aiming to improve long-term results by reducing risk. But these strategies necessarily come with short-term costs.

Downside Protection

One strategy that’s designed to protect against tail risks involves taking short positions that counterbalance the rest of a portfolio, also known as buying downside protection. For example, if an investor is heavily invested in U.S. equities, they may consider investing in derivatives on the Chicago Board Options Exchange (CBOE) Volatility Index (VIX), which correlates to the inverse of the S&P 500 index. (Using short strategies is also one way to invest during a bear market.)

Another way to hedge by buying downside protection is to purchase out-of-the-money put options. When the assets connected to these put options go down, the put options become more valuable. Granted, buying those options costs money, but it can be a strategy to consider for investors who believe the markets are likely to be volatile for a while.

Tail Risk Parity

Tail risk parity is a way to structure a portfolio based on the expectations that events that have a negative impact on one asset class will likely be a boon to others. This requires looking at each asset class in terms of how it might fare in the event of a particular crisis, and then finding an asset class that would likely do well in that same circumstance, and then keeping them in balance within your portfolio.

Managed Futures Funds

Other investors who want to trim their exposure to tail risks may invest in managed futures funds. These funds buy long and short futures contracts in equity indexes, and can thrive during times of crisis in the markets.

The Takeaway

A tail risk is the risk that an event with a low likelihood of happening will happen. And it’s something that investors need to keep in mind. There are a few different ways to mitigate the impact of tail risk in an investment portfolio, but for long-term investors, it can be helpful to keep in mind that tail risk is responsible for most returns over time.

Tail risk and fat tails may seem like granular investing terms, but they do play a role in the markets, which means that every investor can benefit from learning about them, and how they can affect a portfolio.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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