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Key Takeouts
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Covered call strategy targets enhanced income |
Reduced volatility compared to stock-only strategy |
Reduced downside in falling markets |
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Call option premiums provide extra income over and above dividends and franking credits paid on the portfolio. |
Option-writing strategy expected to result in a smoother investment ride than simply holding the underlying portfolio. |
In falling markets, the option premiums received can be used to partially offset the decline in value of the portfolio. |
We are all well aware of the challenges facing income-seeking investors. The RBA cash rate is at a miserable 1%p.a., and tipped by many to go lower – and returns available on cash are not much higher. Term deposits may offer better rates, but lock cash away for a fixed period.
With the Australian sharemarket paying a dividend yield that is high compared to cash rates and yields from most global equity markets, and offering franking credits, many income-seeking Australian investors are naturally attracted to domestic equities. However, this source of income exposes the investor to sharemarket volatility.
To dial back this exposure, and at the same time increase potential income, investors can consider allocating a portion of their Australian sharemarket exposure to the BetaShares Australian Top 20 Equity Yield Maximiser Fund (managed fund) (ASX: YMAX).
How does YMAX work?
The YMAX Fund invests in a portfolio of the 20 largest stocks listed on the ASX, and employs a covered call strategy using options seeking to generate extra income and reduce portfolio volatility compared to holding the share portfolio alone.
The writer of a call option accepts the obligation to sell the underlying shares at the exercise (strike) price if the option is exercised, and in return receives the option premium. Exercise of a call will typically only take place if at expiry the price of the underlying shares is above the exercise price1.
Options with a one-month term to expiry are generally used, with strike prices based on implied volatility rules, but typically written 3%-7% out of the money.
Because the upside for a covered call writer is capped, the written call strategy should generally underperform an uncovered holding of the underlying shares in strongly rising markets.
In falling, neutral and mildly rising markets, however, the strategy is typically expected to outperform, due to the premium income generated from the sale of the call options.
The premium income at least partially offsets the fall in value of the underlying shares in declining markets, and so seeks to reduce the volatility of an uncovered holding.
The figure below illustrates conceptually the enhanced yield the call writing strategy generates, over and above an uncovered holding of the top 20 stocks.
Sources of income in BetaShares Australian Top 20 Equity Yield Maximiser Fund (managed fund)
Illustration only. Not a recommendation to adopt any particular investment strategy.
Income and volatility vs. a passive portfolio
The chart and table below compare the yield of the YMAX Fund with the yield paid on the Solactive Australia 20 Index over the 12 months to 31 August 2019, and also compare annualised volatility.
Over the 12 months to 31 August 2019, YMAX produced a gross yield of 12.1% p.a., compared to a gross yield of 7.4% p.a. for the Solactive Australia 20 Index. YMAX’s volatility at 10.7% p.a. was 2.2% p.a. less than that of the Index.
BetaShares Australian Top 20 Equity Yield Maximiser Fund (managed fund) vs. Solactive Australia 20 Index: 12-month income and volatility to 31 August 2019
Source: BetaShares, Bloomberg. Past performance is not an indicator of future performance. Not a recommendation to adopt any particular investment strategy. *This is an estimate only for this distribution period. The final franking credit amount will be determined as at the end of the financial year and may differ materially from the estimate due to various factors, including changes in the number of units on issue. Not all investors will be able to get the full benefit of franking credits.
Risk of underperformance in bullish markets
While the covered call strategy targets an enhanced yield and lower volatility compared to an uncovered holding of the underlying, when assessing total returns the likelihood of underperformance in a strongly rising market must be considered.
As would be expected, this has been the case during the course of the current bull market. Over the last three years (to 31 August 2019), YMAX has provided a total return of 7.54% p.a., compared to 11.37% p.a. for the Solactive Australia 20 Index. Since inception in November 2012, the fund has returned 6.80% p.a. compared to 10.21% p.a. for the Solactive 20 Index.
YMAX is unlikely to suit investors who hold a bullish outlook on the Australian market, as the core strategy caps potential profits from rising share prices. YMAX is more suited to income-seeking investors who hold a broadly neutral view.
UMAX – a U.S. covered call exposure
BetaShares also offers the S&P 500 Yield Maximiser Fund (managed fund) (ASX: UMAX), a fund that employs a call writing strategy over a portfolio of shares in the S&P 500 Index.
In UMAX’s case, the fund writes index call options over the S&P 500, whereas YMAX writes call options over the individual stocks in the portfolio. Note also that UMAX is not currency-hedged, so investors are exposed to fluctuations in the AUD/USD rate. Depending on how the exchange rate moves, this can work either in favour of, or against, the holder.
The chart and table below compare the yield of the UMAX Fund with the yield paid on the S&P 500 Index over the 12 months to 31 August 2019, and also compare annualised volatility.
Over the 12 months to 31 August 2019, UMAX produced a yield of 5.4% p.a., compared to a yield of 2.0% p.a. for the S&P 500 Index. UMAX’s volatility at 13.9% p.a. was 1.2% p.a. less than that of the Index.
BetaShares S&P 500 Yield Maximiser Fund (managed fund) vs. S&P 500 Index: 12-month income and volatility to 31 August 2019
Source: BetaShares, Bloomberg. Not a recommendation to adopt any particular investment strategy. Past performance is not indicative of future performance.
For more information on the two funds, go to YMAX and UMAX.
There are risks associated with investing in the Funds, including market risk and use of options risk. The value of an investment and income distributions can go down as well as up. Before making an investment decision investors should consider the relevant PDS and their particular circumstances, including their tolerance for risk, and obtain financial advice.
1. Written calls can be vulnerable to early exercise if the option is in the money and the stock is about to go ex-dividend.
