Covered calls: a strategy for the spotlight

Interest rates on cash are at rock bottom. The yield on a 10-year UK or US government bond is just more than 2 per cent. Once you have allowed for inflation, holding these assets is a recipe for loss. And that is not allowing for the potential for capital loss by holding government debt at this stage in the economic cycle. Investors will have to look beyond traditional options for income.

Step forward equities: the yield on the FTSE 100 index of large UK stocks exceeded that of 10-year UK government bonds early last year. This premium does not look like reversing any time soon.

Fixed interest has long been investors’ favoured source of income. However, one lesson from the financial crisis of 2007-09, when credit markets froze, was that liquidity can be a problem for bonds in extreme conditions. Stockmarkets, however, remained liquid.

The outlook is a positive one for income from dividends. Companies are, in general, well capitalised. They have a number of choices available to them with regard to the piles of cash they are sitting on. They can invest it in growing organically, heading down the mergers and acquisitions trail or returning it to their investors by paying them dividends or buying back shares. For now, the most likely route is the latter. But investors have become uneasy about equity exposure since the financial crisis.

Demand for lowering the risk of equities and enhancing their yield has been a long term trend. It ties in neatly with the recently coined phrase, “demographic disdain for equity risk”.There are three elements to this:

• “Safe yield” is in demand, as investors shun “average” expected returns from equity markets while risk is still perceived to be heightened

• Demographics continue to support bonds over equities. This is because developed markets have age profiles increasingly skewed upwards, implying an ingrained preference for ‘safe’ assets

• Emerging market savers aren’t helping either, being discouraged from equity investments due, among other reasons, to less regulated companies and markets

The areas of the equity market with the high quality companies, strong balance sheets and high dividends are in demand, with much of the rest failing to fit investors’ requirements for safety and yield. In short, investors increasingly want a reliable source of income from equities, without the rollercoaster volatility.

In spite of rising yields, they arguably need more yield than a plain vanilla equity portfolio can provide. While equity income is relatively attractive relative to government bonds, the January yield on the FTSE 100 - 3.5 per cent - is still slightly less than the January consumer prices index rate of 3.6 per cent, let alone the retail prices index rate of 3.9 per cent.

Covered call strategy

However, some strategies allow investors to achieve a higher level of income from the equities they hold with constrained volatility. These include covered call option sales, under which an investor sells or writes options to buy stocks in their portfolio for an agreed price. A covered call or ‘buy write’ strategy can produce the excess income, over and above dividend yields. Adding short call positions to a portfolio has been shown to reduce volatility and enhance returns over the long term, and has become a significant industry trend, particularly with the market making such strong gains year to date, which few expect to extend dramatically further.

Gains in a rapidly rising market are limited due to the sale of the call options. But this can be managed by trading these options on a daily basis. If the money manager has the capability to trade the calls daily then that will tune the strategy more finely to the market’s behaviour.

Call options are sold on each scheduled trading day and expire at an agreed number of trading days after. Selling them daily enables investors to react more closely to market trends, as they can benefit from the increase in volatility during a bearish market and more closely follow an upward market.

Volatility, as measured by the Vix index, was greater over the summer of 2011 than at any time since the financial crisis, which peaked in late October 2008. Recent high volatility in the stockmarket bodes well for a fund using the covered call strategy, as it may sell calls further out of the money. In other words, the fund can participate in more equity growth before it is capped. It also leaves the fund well positioned to resist in the event of the market pulling back, as higher volatility means call sellers can charge higher premiums for performance cushion.

This strategy can be employed through a portfolio of actively managed stocks, or by selling calls on a particular index. The benefit of the latter, just as with buying an exchange-traded fund over an actively managed fund, is efficiency and transparency. The investor must ask themselves whether it is worth paying for active management that can deliver excess returns across the market cycle.

While there is no such thing as a free lunch, the covered call strategy delivers enhanced income at the potential cost of reduced capital gains in rapidly rising markets. Market-beating income with reduced volatility is achievable through a strategy available to retail investors.

Sisouphan Tran is head of Harewood Solutions, a BNP Paribas structured investments provider