Sunday, April 22, 2012

Investor Traps: Covered Call ETFs

One significant challenge for investors is to ignore information that they discover while researching investment options. A classic example of this is information which seems straight forward but may not be suitable for the portfolio strategy an investor is trying to implement. Part of the challenge is that the marketing arm of the product manufacturers (mutual fund or EFT companies specifically) do a great job of hyping the benefits and an even greater job of downplaying or ignoring the risks of the product. Often new investment products are created for a specific requirement, such as enhancing income or hedging a long position and then they become popular as the “new hot product”!
Let’s look at the example of Jane Smith, an investor in her 60’s approaching retirement shortly and managing her portfolio with a conventional diversified ETF portfolio. Her holdings include ETF’s tracking the TSX60, the S&P 500, EAFE Index (Europe, Australia & Far East) and the Dex Bond Universe. Jane has a strategic asset allocation that is 75% fixed income and 25% equity exposure. This strategy is designed to protect her substantial RRSP holdings from market volatility while holding sufficient equity exposure to protect against any uptick in inflation through equity growth. Jane is looking for returns of inflation plus 2%.
In researching her investment options Jane comes across a new ETF that has been gaining in popularity; a fund that writes covered calls on bank shares. In checking out the ETF Jane sees that the current yield is over 6% at a time when her fixed income portfolio is yielding 3.68% in comparison. Given her concerns about the low interest rates on her large fixed income portfolio Jane contemplates reducing her fixed income ETF holdings by 10% of the portfolio and adding 10% to a “covered call elf” holding.
What Could Go Wrong?
In further reviewing the covered call strategy Jane starts to feel a little less excited about her new strategy. While current yield is great, Jane begins to understand that the greater yield comes with certain risks that are not always readily apparent. That prompts Jane to run through a few scenarios to see how her “new” strategy would react to certain market changes that might occur.

1-      What if interest rates remain low or even go lower? The covered call strategy is based upon implied volatility in stock prices so it does not directly react to interest rate changes. As such it does not directly assist the portfolio to have low interest rates; however if the ETF continues to provide a 6% yield it should have a positive impact on Jane’s portfolio.....right? In fact, since current yield is defined as recent period income divided by portfolio value, a $6 income on a $100 portfolio provides a 6% current yield. If the portfolio drops in value to $75, the current yield becomes 8%. In looking at the 1 year performance of the new fund (just over 1 year old now) Jane discovers the rate of return has been -1.5% from March 2011 to March 2012. That seems perplexing given the fund is yielding such a high amount? Maybe current yield is not the best way to look at this ETF!

2-      What if rates rise sharply? If rates rise the value of Jane’s existing fixed income will likely drop. Fixed income values generally move opposite of interest rates. Obviously the higher rate scenario favours holding covered calls versus fixed income..... right. Well, maybe! If rates rise what will the bank stocks held by the ETF do? Will investors sell stock and buy fixed income when rates rise? If so what will happen to the value of the underlying bank stock? In fact, banks tend to benefit from higher interest rates (think of interest rate spreads as banks raise mortgage rates and credit card rates). While no outcome is guaranteed, Jane is comfortable that if rates rise this strategy should be either slightly positive or neutral in her portfolio.

3-      What if stocks go on a big bull run? If bank stocks benefit from positive stock markets there could well be a doubling or tripling of some bank stocks. After all, TD Bank common stock went from the high $20’s to the low $70’s after the 2008 crash ended! Holding the long positions on bank stock in the ETF might bring a real growth spurt to the portfolio. Right? Well, actually no. While the ETF holds a lot of bank stock, the gain from an increase in the underlying stock values would benefit the investors that bought the covered call options. If a stock was valued at $60 and a covered call was sold at $62.00, the ETF would make a profit of $2.00 plus the option premium of perhaps $1.00. If the bank stock went to $80/share the ETF would still only see a maximum of $3.00 from the $20.00 increase! Suddenly giving up a $20/share gain for $3 does not seem as positive.

4-      What if the stock market plunges downward?  The covered call strategy is a “defensive strategy” (according to the marketing material anyway) so it must protect my portfolio from large losses.....right? It would seem to make sense that the offset to sacrificing large gains when markets rise (scenario 3 above) would be that my portfolio would be sheltered from large losses in return..... right?  Well, actually, no! That is not the case with covered calls. If the bank stocks dropped from $60/share to $40/share the fund would need to hold the shares for the length of time that the call option remains in place to insure the option remains a “covered call” and not a “naked call”. The fund holds the stock regardless of the market performance and the only income to offset the loss is the small call premium (our $1 theoretical premium as above). The net result is that the fund looses $19/share instead of the $20/share the market drop infers. 

Given the above analysis, Jane pulls out her original Investment Policy Statement and reviews her strategy. The equity holdings are designed to provide growth which protects the portfolio from being eroded by inflation. That is accomplished by using gains from a rising stock market to cushion any losses in fixed income values caused by inflation. Since the covered call strategy limits market gains the covered call strategy works against Jane’s overall strategy.
Jane's original strategy called for limited equity exposure to ensure stock market losses do not diminish Jane’s nest egg. The covered call strategy leaves the portfolio exposed to any significant market drops so that also works against Jane’s original strategy. 

Decision: In looking at all options Jane realizes that the covered call option is a higher risk strategy than holding fixed income and it has the potential to 1) dampen equity growth, 2) expose the portfolio to large equity losses, and 3) in a low volatility stock market with concurrent low interest rates, it could increase current yield slightly. In short the covered call strategy can help a little or hurt a lot, but it cannot significantly improve her portfolio. Jane reviews her portfolio performance against her goal of making returns of “inflation plus 2%” and finds she is currently still meeting her target rate of return. As such she decides not to utilize the covered call ETF that all her friends are excited about. What she will do is file away the information. Every product serves a purpose but not every purpose serves a portfolio strategy. In this case doing what is popular with investors today and what appears to offer some immediate benefit, would actually weaken the investment strategy and change the risk profile on Jane's portfolio. Sacrificing equity gains while taking full equity market risk is a poor trade off. As well, not making the addition to the portfolio keeps the MER lower, reduces trading costs to rebalance the portfolio, and makes the portfolio simpler to monitor. Jane knows that an investment portfolio is like a bar of soap....the more you handle it the smaller it tends to get! 

Note: Covered calls on bank equities were the most popular strategic ETFs in the first quarter of 2012. The largest volume growth was a bank shares focused covered call ETF that provided returns of just over 7%. Holding direct common shares in TD bank provided over 10% capital gains as well as additional dividend income. The covered call strategy provided an enhancement in returns versus fixed income however it provides the risk profile of equity. When properly compared to narrow focused bank equity returns the results were less than stellar. The message is not that covered calls are a bad strategy for everybody. The important message is that any security you purchase needs to support your overall investment strategy, your portfolio risk profile, and your investment return requirement. Covered call strategies are marketed as a lower risk strategy and generally compared to fixed income investments. In fact they are equity and should be considered a higher risk strategy with a potential downside far greater than any typical fixed income strategy. Risking a 20% or 30% downside or missing a 20% or 30% gain are high prices to pay for the extra yield you may see in the short term.
sois mike