Though the U.S. markets are climbing once again and are hovering around their multi-year highs buoyed by Fed easing policies and improving economy conditions, volatility seems to be crawling back into the market.
The economic activity in the U.S. is picking up rapidly with stronger-than-expected manufacturing growth and construction spending. The housing market is showing strong recovery with higher home prices, rising demand, more home-building permits and new construction plans while the job market is also healing faster than expected.
Apart from these factors, global economic conditions are also on the rise with improving fundamentals in Europe and China (read: 3 Top Performing ETFs of November).
Investors are concerned that strings of upbeat economic data would bring the tapering sooner rather than later. Further, consumer sentiment continued to slide in November after falling in October, giving mixed signals on the health of the economy.
This, along with ultra-low rates, led to investor worry about their income safety and consequently their choice of a less volatile portfolio that gives higher returns. One such portfolio that seems ideal for the current market environment is the ‘Covered Call Strategy’. This is because the strategy provides downside protection, while at the same time offers some capital gains if the underlying asset rallies.
Covered Call Strategy Explained
A covered call (often called buy-write) is an option strategy whereby an investor holds a long position in an asset and sells (or writes) call options on that same asset. With this process, the strategy aims to generate additional monthly income from the call option (premiums collected).
Let’s see how it works. If the product stays flat or declines slightly, investors keep the premium and their stock. However, if prices rise, investors only receive the premium and the stocks are sold at the price that was agreed upon in the covered call.
As such, the products would probably underperform in the bull markets, as the covered call strategy eats away at the gain potential especially with a short time horizon (see: all the Long-Short ETFs here).
How to Play?
For investors seeking to make a play on the broad U.S. equity indices using this strategy could consider the following three ETFs:
PowerShares S&P 500 BuyWrite Portfolio ETF (PBP)
This fund tracks the CBOE S&P 500 BuyWrite Index before fees and expenses. The index measures the theoretical performance of a covered call strategy on the S&P 500 index by writing at or out-of-the-money call options, listed on the Chicago Board Options Exchange (CBOE), which is due for expiry the following month (read: Time to Hedge Your Risk with These 3 ETFs).
The fund has amassed $196.1 million in AUM and trades in average daily volume of nearly 67,000 shares a day. Though the product is a bit pricey when compared to other choices in the market, charging 75 bps in annual fees, this could be making up in terms of yield. The ETF has an annual yield of 5.13% mainly due to the premium received by writing the call options.
Horizons S&P 500 Covered Call ETF (HSPX)
This ETF seeks to match the performance of the S&P 500 Stock Covered Call Index, before fees and expenses. The product will hold a long position in the stocks of the S&P 500 Index while at the same time, will short (write) call options on option-eligible stocks in the S&P 500 Index.
This fund debuted in June this year and has accumulated $26.4 million in total asset base so far. Volume is light as it exchanges nearly 12,000 shares in hand on an average daily basis. The ETF has an expense ratio of 0.65% and yields 0.77% in annual dividends, though it doesn’t yet have a good sample size for payouts (read: Horizons Launches Covered Call ETF (HSPX - ETF report)).
Barclays iPath S&P 500 BuyWrite Index ETN (BWV)
This is an ETN option and tracks the similar index as that of PBP. Unlike PBP, the ETN carries credit risk from the issuing institution – Barclays. The note is less popular and less liquid as depicted by AUM of $9.6 million and average volume of under 3,000 shares. The ETN charges 0.75% in fees and expenses.
These products are appropriate for investors seeking high levels of current income and a hedged exposure to the large cap U.S equities. It is worth noting that the funds will lag significantly during boom times, but will be an interesting choice in flat or declining markets, especially for investors seeking extra income in the current low rate environment.
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