So-called  “covered call” or “buy write” investment strategies have been a popular method used by investors to enhance the income returns from owning shares.  This note sets out some empirical evidence on the historic success of such a strategy over US equities and, specifically, a strategy similar to the one underpinning the BetaShares S&P 500 Yield Maximiser Fund (managed fund) (ASX Code: UMAX).

Buy write or covered call strategies

As detailed in an earlier blog post,  a “covered call” or “buy write”  strategy involves selling call options against an investor’s share portfolio to gain extra income. By selling a call, investors earn income in exchange for giving up the right to some upside share price appreciation, if the share prices rise beyond a certain level (these are called ‘premiums’).

As should be apparent, such an options strategy is most likely to perform well when share prices are at best rising only modestly, or are trending sideways or down. The strategy will likely detract from performance in periods when share prices are rising strongly.

The evidence

Various studies have explored the evidence over whether buy write strategies are able to outperform the market.  One problem with these studies, however, is that – especially over shorter time periods – the results are sensitive to market conditions.  As noted above, for example, “buy write” strategies are likely to under perform during strong bull market periods, with potential to outperform in weaker market conditions.

The chart below presents the long-term evidence on the S&P 500’s BXY Index, maintained by the Chicago Board Options Exchange (CBOE). This index tracks a strategy of holding the S&P 500 index and also selling monthly call options against the index which are 2% out of the money (OTM) – i.e their strike prices are 2% above the S&P 500’s current index level.  The results are  instructive in highlighting the effectiveness of a buy-write strategy over US equities, particularly due to the extensive track record of the BXY index. In addition, the strategy employed by the BXY index is similar (but not identical) to the strategy employed by BetaShares S&P 500 Yield Maximiser Fund (managed fund) (ASX Code: UMAX). Please note however that the strategy employed by UMAX differs from the BXY strategy in that it uses the volatility of the underlying security as an input for selecting the OTM strike (i.e. rather than strictly 2%).

As seen in the chart below, the BXY strategy has tended to outperform the market during periods when the market was trending sideways to down, though under perform when the market was rising strongly. Indeed, the strategy has generally underperformed in recent years due to the strong United States bull market.

That said, what’s noteworthy is that the broad trend of relative performance has been upward – and over the entire period studied, the BXY strategy ended up with positive relative performance as compared to the S&P 500 Index – in other words, over market cycles, the buy-write strategy outperformed the underlying index.  Indeed, as was the case at the market bottoms in both March 2003 and March 2009  out performance by the BXY Index during the previous two strong bear market periods more than made up for the years of under performance during stronger bull market periods.

What’s more, even if we concede the BXY index has only tracked market performance over this period – the table below show it has done so with less volatility in returns.  In particular, the regular receipt of option premium income helped cushion downside volatility.

Illustrative only. Past performance is not an indicator of future performance. The performance of the BXY strategy is not indicative of the future performance of UMAX.

In the 26 years to end-December 2014, for example, the standard deviation in annual total returns for the S&P 500 index was 18.3%, compared with only 15% for the BXY Index (a 20% reduction in volatility).   The S&P 500 Index also suffered 5 negative returns years over this period, compared with only 3 for the BXY Index.  And during the last two serious bear market years (2008 and 2002), the loss on the BXY Index was less than that for the S&P 500 Index.

 Yield enhancement

The other factor to note is that buy-write option strategies change the composition of total returns from capital growth toward upfront income.  For example, between end-September 2014 and end-June 2015, the UMAX fund produced a total return of 15.5%, and a price return of 11.7% – implying an income return of 3.8%.

By contrast, the total return on the S&P 500 index over this period was 21.1%, of which only 1.8% came as income return with 19.2% as a capital return.  This is to be expected: the strategy earns extra income upfront by selling call options, though is then likely to participate in relative less capital growth when market prices are rising strongly.

Past performance is not an indicator of future returns.

All up, the results suggest that a “buy write” strategy over US equities can potentially provide enhanced total returns relative to the broad US sharemarket. One possible reason for this apparent “excess return” potential is that option buyers tend to factor into option prices greater market volatility than actually comes to pass – meaning betting against strong market price gains tends to generate more gains than losses over time. That said, as demonstrated, the strategy does not always work, especially in periods when prices are rising strongly – as has been evident in the United States of late.

Irrespective of short-term relative performance, moreover, the evidence shows a “buy write” strategy does appear to consistently lower the volatility of returns over time – and provide some downside protection when markets are weak. Finally, as can be seen by the, albeit short, historical results of our UMAX fund, the “buy write” strategy over US equities has also produced relatively more returns in the form of income than the broad sharemarket – with recent history showing this income return has been around twice that of the S&P 500’s income return.