Although interest rates have risen from their longer-term lows, the yield on the 10-Year U.S. Treasury is bouncing around 3%, unsure of where to go next. And that still-paltry yield is why there’s been no shortage of investment products engineered to deliver extra yield to investors.
That includes buy-write exchange-traded funds and exchange-traded notes, which employ covered call and put-writing strategies designed to generate additional income and provide a degree of downside protection. Call-writing strategies involve buying a stock (or a basket of stocks) and offsetting that by selling or writing a call option on those stocks (an option to buy a security at an agreed-upon price by a certain expiration date). Call options earn a premium for the seller, who benefits by keeping both the premium and the underlying stock in a flat or slightly falling market. But in rising markets, the underlying security is sold at the agreed-upon strike price and the seller keeps only the premium on selling the call option. The upshot: This strategy isn’t ideal in bull markets because it caps the upside potential for the seller.
Put-writing involves selling a put option that gives the buyer the right, but not the obligation, to sell the underlying stock or basket of stocks at the agreed-upon exercise price by the specified expiration date. Buying a put option is a bearish bet because the buyer profits only if the security’s share price falls below the strike price, which allows the buyer to sell the stock at a certain price and then buy it back at a cheaper price. If the underlying security appreciates in value above the strike price, the buyer loses only the premium paid to buy the option. Put options earn a premium for the seller, but the seller could lose money if the asset price falls below the strike price and the buyer exercises the option at the strike price.
Available Options
Investors looking to limit the downside of their investments not only have put and call options to turn to but also indexes and the funds that track them. One of these is the CBOE S&P 500 BuyWrite Index. This index owns an S&P 500 portfolio and sells the equivalent number of near-term, slightly out-of-the-money S&P 500 covered call options, generally on the third Friday of each month. (Out-of-the-money calls have a strike price that’s above the current trading price of the underlying security.)
The CBOE S&P 500 PutWrite Index, meanwhile, measures the performance of a hypothetical portfolio that sells S&P 500 put options against collateralized cash reserves held in a money market account at one- and three-month Treasury bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in T-bills can finance the maximum possible loss from the final settlement of the S&P 500 puts.
A study done by Hewitt EnnisKnupp, an investment consulting company, found that from June 1986 through January 2012 the CBOE S&P 500 BuyWrite Index produced comparable returns to the S&P 500 but with lower volatility. In addition, Ennis Knupp + Associates (before it was bought by Hewitt Associates) did a study that found the CBOE S&P 500 PutWrite Index earned higher returns than the S&P 500 with lower volatility from its 1986 inception through mid-2008.
Sounds great, but that’s old news and it’s not so clear whether buy-write funds have delivered the goods in recent times. The oldest buy-write fund is the Invesco S&P 500 BuyWrite ETF (PBP), which based on the CBOE S&P 500 BuyWrite Index. The strategy works by holding a long position indexed to the S&P 500 Index and writing, or selling a succession of covered call options with an exercise price at or above the prevailing price level of the S&P 500 Index. Dividends paid on the component stocks underlying the S&P 500 and the dollar value of option premiums received from written options are reinvested. PBP’s recent 12-month distribution was 3.23%.
The Invesco fund produced a 4.75% annualized return for the 10 years ended June 29, 2018. That’s more than five percentage points lower on an annualized basis than the SPDR S&P 500 ETF’s (SPY) 10.17% annualized return over the same period. PBP achieved its return with lower volatility than the SPY Fund—a 10-year standard deviation of around 11% versus 14.7% for SPY. But that lower volatility hasn’t been low enough to compensate for the lower return. PBP’s Sharpe ratio (the measure of its volatility-adjusted returns or return per unit of volatility) of 0.45 was considerably less than SPY’s ratio of 0.71 for the past decade.
Another fund in this category is the Horizons S&P 500 Covered Call ETF (HSPX), which tracks the CBOE S&P 500 2% OTM BuyWrite Index. That index buys a S&P 500 stock portfolio and writes near-term 2% out-of-the-money calls that correspond to that portfolio. That means the exercise price is 2% above the prevailing index level.