Many investors have now transitioned to a lower stock allocation during the midst of this early 2016 decline. In fact, the stock market drop has likely spawned a wave of realization that it’s time for investors to adopt a low-volatility structure until the storm passes.
A conventional and highly touted method has been to own stocks with lower historical price fluctuations than their peers like the iShares MSCI USA Minimum Volatility ETF (USMV). However, there is also another way for ETF investors to own a basket of stocks with built-in options to collect income and potentially reduce price volatility.
Covered call ETFs are also often referred to as a “buy-write” options strategy. This process involves owning a group of publicly traded stocks and selling call options on the underlying securities to collect the premium. This can be done by sophisticated investors on individual positions or you can effectively own an ETF or two that will do it for you on a diversified basket of stocks.
The end goal is to collect income from the options contracts, which will admittedly reduce the effectiveness of these ETFs during a sustained uptrend in the market. However, these funds have shown far less relative drawdown than their fully loaded index peers during the last two recent corrections.
2 Covered Call ETFs to Buy
The oldest and most established fund in this group is the PowerShares S&P 500 BuyWrite Portfolio (PBP). This ETF debuted in 2007 and has accumulated $314 million in assets. As you can see on the chart below, PBP has been able to sidestep a great deal of the decline versus the broad-market SPDR S&P 500 ETF (SPY). It was also able to accomplish that same feat in the summer 2015 swoon as well.
It’s worth noting that over longer periods of time, the PBP performance story falls short of the stock-only SPY. This is primarily due to the drag of the options buy-write strategy on 3-, 5-, and 10-year time horizons. In addition, PDP charges a premium expense ratio of 0.75% for the implementation of its unique approach.
The income from PBP is interesting because it often experiences big changes over time. Distributions are paid on a quarterly basis to shareholders and over the last 12-months the trailing yield is 5.78%. Some of those distributions have included short and long-term capital gains as well.
Another worthy contender in this space is the Recon Capital NASDAQ 100 Covered Call ETF (QYLD). This ETF implements a similar strategy based on the NASDAQ-100 Index. The end result is a more concentrated mix of stocks with concentrations in technology and consumer discretionary sectors.
This ETF has been able to achieve a similar pattern of reduced drawdown relative to the PowerShares QQQ (QQQ) during periods of market stress.
QYLD charges an expense ratio of 0.6%, and income is distributed on a monthly basis to shareholders. This may be a more attractive feature for income investors who are searching for a more regular dividend stream. The trailing 12-month distributions indicate a yield of 10.2% based on the current share price of QYLD.
The Bottom Line
These buy-write strategies have traditionally been a more obscure way to generate income while reducing drawdown during sideways or falling markets. This likely means that they are going to be more of a tactical opportunity in the context of a diversified portfolio rather than a dedicated core position.
Investors considering these funds should closely research the underlying mechanics of how the income is generated and compare against other potential low-volatility alternatives as well.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. To get more investor insights from FMD Capital, visit their blog. Click here to download their latest special report, The Strategic Approach to Income Investing. Learn More: Why I love ETFs, And You Should Too