We compare what’s driving solutions that offer the same yield yet widely different returns
Getting your UK equity income allocation right: not all covered call strategies are equal
By Morgane Delledonne, ETF Investment Strategist, BMO Global Asset Management
The renewed weakness of sterling amid the UK’s seemingly never-ending political uncertainty will likely benefit the FTSE 100 index. Around two-thirds of the index’s constituents derive their earnings overseas and so have limited global direct exposure to the UK economy, and therefore little or no impact from a potential hard Brexit. Utilities and financials are the most sensitive sectors to Brexit risks but companies in these industries represent only one-fifth of the index.
FTSE 100 looks very attractive versus other major developed markets
The price-to-earnings ratio for the FTSE 100 currently stands at 17.5x, which is almost one standard deviation below its five-year average (26.9x) and reflects the discount resulting from the political uncertainty around the Conservative party’s leadership contest, and therefore who will be the UK’s next Prime Minister. The outcome of the contest will have major implications for the Brexit endgame, after three-years of wrangling, and has significantly increased the prospect of a no-deal. This is considered by the majority of domestic companies to be the worst Brexit scenario, and has therefore materially impacted sterling. However, for the FTSE 100, where the majority of constituent companies convert their global earnings back into sterling, this makes for a very attractive current opportunity compared to other major developed market indices.
How we capture the FTSE 100
The BMO Enhanced Income UK Equity strategy physically replicates the FTSE 100 index as a core holding with no active bet* and has a covered call overlay to enhance the overall yield of the fund. A covered call strategy will typically underperform the replicated index in periods when the underlying market is strongly rising and outperform when the market is falling or trading range-bound.
In order to enhance yield without forfeiting the entire potential upside participation, the BMO Enhanced Income UK Equity ETF sells index call options against approximately half of the equity portfolio, thus combining income and investment growth.
Not all covered call strategies are equal
There are other covered call UK equity strategies in the market, which generate a similar overall fund yield but employ a different approach to achieving this yield, which can lead to very different fund characteristics. This is important for those investors considering how their UK equity allocation will affect their overall investment portfolio. Such alternative covered call strategies involve investing in particular stocks for alpha-generation while simultaneously selling individual call options on some of those stocks, which can introduce idiosyncratic risk.
The BMO UK Enhanced Income Equity strategy uses index call options, which mitigate idiosyncratic risks. The BMO fund also targets between 40% to 60% coverage in a systematic manner, depending on volatility.