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There are many funds today offering some version of covered call strategy (BuyWrite strategy). We have been asked “What do they do?” and “Are they a good addition to a diversified and allocated portfolio?”
Classification Problem:
The funds’ approaches vary from generally passive to aggressively active. Some work with underlying indices and some work with actively selected stock portfolios. Some use covered calls on their entire portfolio all of the time, while other use covered calls on part of their portfolio part of the time. Some only sell calls, while some also buy puts to protect against major losses. Some pay distributions and some do not. Some do other things that may or may not be clear to investors or consistent from period-to-period.
These issues point to one of the pitfalls of classifying funds, particularly actively managed funds that provide wide manager flexibility. It is important to look beyond the fund category and fund name to the specifics of what a fund does.
Some funds in the category may do extremely well or extremely badly, but unless they follow the pure strategy, it is difficult to attribute the return to covered calls versus the other methods simultaneously used in the portfolio.
Pure Strategy Funds:
In this report, we will strip away those return attribution uncertainties by focusing on two funds (BEP and BWV) that purport to strictly adhere to the covered call strategy on the S&P 500 index as described by the CBOE benchmark (BXM). [fund descriptions at end of article]
What does “BuyWrite” mean? (from the CBOE website)
“A ‘Buy-Write’ strategy generally is considered to be an investment strategy in which an investor buys a stock or a basket of stocks, and also writes covered call options that correspond to the stock or basket of stocks.
Buy-Write strategies provide option premium income that can help cushion downside moves in an equity portfolio, but Buy-Writes often under perform stocks in rising markets [because the calls cap the potential gains on the underlying portfolio]. Thus, some Buy-Write strategies significantly outperformed stocks in 2000 when stock prices fell, but Buy-Writes tended to under perform stocks in the years 1995 - 1998 when the S&P 500 rose by more than 20% per year.
Buy-Write strategies have an added attraction to some investors in that Buy-Writes can help lessen the overall volatility in many portfolios.”
Are there benchmarks?
The CBOE created the S&P 500 BuyWrite (symbol BXM) index in 2002. That is the gold standard to evaluate the returns of covered call funds.
How well does the strategy work? (CBOE site)
“In September 2004 the Ibbotson Associates consulting firm issued a case study on the investment strategy represented by the CBOE S&P 500 BuyWrite Index. The study was three-fold: 1) assess risk-adjusted performance of the BXM; 2) evaluate the role of this covered-call strategy in a portfolio; and 3) establish if an investor can implement the strategy.”
A four page summary of the Ibbtoson study is available for download. Ibbotson found higher returns and much lower volatility for a the BuyWrite index versus the S&P 500 alone.
Along the same lines, Callan Associates did a study of the 18 year history of BXM through 08/07 (download report). CBOE says in reference to the report:
“The BXM underperformed the S&P 500 during most rising equity markets and consistently outperformed the S&P 500 in all periods of declining equity markets, demonstrating the return cushion provided by income from writing the calls.
The BXM generates a return pattern different from that of the S&P 500, offering a source of potential diversification. The addition of the BXM to a diversified investor portfolio would have generated significant improvement in risk-adjusted performance over the past 18 years.”
[from Barclay’s iPathETN site] On a 5-year basis BXM returned 9.31% annually and had a standard deviation of 5.71%, while the S&P 500 returned 12.39% and had a standard deviation of 8.18%.
Over 5 years the approximate Sharpe ratio (return in excess of risk free return divided by standard deviation) is approximately equal for the both approaches.
The return differences over various time periods are shown below.
Cyclic nature of the strategy: (charts from Barclays iPathETN site)
The charts below shows the rolling 5-year returns and 5-year rolling standard deviaitons of the BXM versus the S&P 500, illustrating the cyclic nature of the strategy.
Similarly, the chart below shows the call premiums as a percent of the underlying index, showing the cyclic nature of the opportunity to develop strong credits though the strategy.
The charts confirm the Ibottson and Callan studies. In flat or declining markets, the BXM outperforms the S&P 500. In strongly rising markets, the S&P 500 outperforms the BXM. However, in all periods the BXM provides a lower volatility.
How do BEP and BWV perform?
We plotted only BXM and BEP, because BWV has almost no history. However, BWV is a contractual obligation to exactly track BXM, less the 75 basis annual management fee. Therefore, you can see the BWV will be a more steady performer (this presumes that www.stockCharts.com plotted total return for BEP and not just price).
Our Recommendation:
YES to BEP and BWV during certain phases of market cycle. We would favor BWV or BEP.
NO to other funds that follow complex, difficult to understand strategies.
The covered call strategy is a conservative strategy with increasing appropriateness for investors as they grow older, when volatility is a bigger issue.
Our Logic:
We tend to favor active management of index funds over use of actively managed funds. That minimizes overhap of holdings and allows us to know more clearly what we are buying and why. To the extent that actively managed funds are used, we favor those with a clearly expressed and transparent process with leeway constraints that cause them to invest in the same way that they describe themselves in their fund name and short summaries.
Based on our philosophy, we favor BEP and BWV. They pursue the pure strategy. We can buy them and be confident of what they seek to do for our portfolio. We would tend deploy them in flat to declining markets and tend to avoid them in strongly rising markets.
We favor BMV over BEP for three reasons:
- BMV 75 basis point management fee that is 32 basis points lower than BEP,
- it will perfectly track the BXM less fees by operation of the debenture contract, and
- it will not create current taxation, which should be more tax efficient.
BEP as you can see from the chart is having some difficulty with tracking error, has a higher expense ratio and generates current ordinary tax rate income.
We would avoid those covered call category funds that are actively managed and that also pursue various other strategies, until and unless they have at least 5 years of history under the same portfolio manager.
If we are looking for an index covered call method, we would also avoid those covered call category funds that seem to be there simply because no other category fits, but which are engaged in number of other practices that we may not understand or that can vary from period-to-period. We do not believe in chasing performance in and of itself. We require that we understand why and how money is being made.
For the same reason that Warren Buffet will not buy a company whose business is too hard to understand, we will not buy a fund whose process is too hard to understand. Exotic methods are often just a marketing gimmick and justification for higher fees.
Lastly, many covered call category funds are quite illiquid with spotty intra-day trading opportunities and very wide Bid/Ask spreads. Significant investors would possibly move the market by the transactions. Both BEP and BWV suffer from liquidity problems at this stage too.
For those who manage their own money intensively, buying an S&P index fund such as SPY (8 basis point expense ratio) and their own calls, may be a more cost effective approach.
We have not attempted yet to determine if the tax efficiency of the BWV pays for the 75 basis point management fee. The BWV fee does, however, allow the investor to devote time to other questions, to avoid the necessary continuing attention to process and to avoid the transaction costs of call writing.
Richard Shaw
QVM Group LLC
Registered Investment Advisor
Disclosure: author does not own any security mentioned.
Fund descriptions from the sponsor’s sites:
BEP: The Fund’s investment objective is to seek total returns through a covered call strategy that seeks to approximate the performance, less fees and expenses, of the CBOE S&P 500 BuyWrite. The Fund will pursue its investment objective principally through a two-part strategy. First, the Fund will invest the proceeds in all of the common stocks included in the S&P 500 Index weighted in the same proportions as the S&P 500 Index and/or other investments that have economic characteristics similar to the securities that comprise that Index. Second, each calendar month during the term of the Fund, the Fund will write (sell) one-month call options on the S&P 500 Index (”Written Options”).
BWV: iPath Exchange Traded Notes (ETNs) are senior, unsubordinated, unsecured debt securities issued by Barclays Bank PLC delivering exposure to the returns of a market or strategy with the trading flexibility of an equity. Investors can trade iPath ETNs on an exchange at market price or receive a cash payment at the scheduled maturity or at early redemption, based on the performance of the index, less investor fees. The iPath CBOE S&P 500 BuyWrite Index ETN offers investors cost-effective and tax-efficient exposure to the CBOE S&P 500 BuyWrite Index, commonly known as the BXM Index (the “Index”). The Index is designed to measure the total rate of return of a hypothetical “buy-write”, or “covered call”, strategy on the S&P 500 Index. This strategy consists of a hypothetical portfolio consisting of a “long” position indexed to the S&P 500 Index (i.e. purchasing the common stocks included in the S&P 500 Index) and the sale of a succession of one-month, at– or slightly out-of-the-money S&P 500 Index call options that are listed on the Chicago Board Options Exchange (”CBOE”).
