Equity markets stalled in 2015 after a relentless six-year rise from the depths of the Great Recession. Last year’s stagnant market, even with its bearish tilt, was a perfect set-up for buy-write plays.
A buy-write is an option strategy featuring a stock purchase (that’s the “buy” part) along with the sale (a “write”) of a related option. Typically, these are call options. Deemed “covered calls,” they offset the otherwise unlimited liability associated with selling options through ownership of the underlying stock. The object of the strategy is income production. The premium earned for selling the options is retained if the contracts remain unexercised—a likely occurrence in a flat-to-bearish market.
That’s not to say there’s no risk. If the market value of the stock spikes, pushing the options into the money, shares may be called away at the strike price, leaving the writer with just the premium and perhaps a bit more. What’s at risk is the upside potential of the stock, a sort of opportunity cost.
Should the value of the underlying stock decline instead, the call premium provides a modicum of downside protection.
A number of exchange traded funds engage exclusively in buy-writes. Most use call options. A couple, though, feature puts. Selling puts rewards investors in a stagnant or rising market if the underlying stock’s market price exceeds the put’s strike price; a downtrending market is anathema to this particular variation on the strategy.
It’s worth a look at these ETFs to see how successful they’ve been in providing income and limiting risk.
The PowerShares S&P 500 BuyWrite Portfolio (NYSE Arca: PBP) writes at-the-money calls on its portfolio of S&P 500 securities. Launched in 2007, PBP is well established with $308 million in assets and an average daily volume of 109,000 shares.
Over the past two years, PBP’s maximum drawdown was significantly less than the biggest hit taken by the SPDR S&P 500 ETF (NYSE Arca: SPY), a proxy for the blue chip index. Drawdowns represent peak-to-trough losses sustained before new price peaks are attained (see Table 1).
Another metric of downside risk, Value at Risk (VaR), typifies the expected loss within a given timeframe. Essentially, VaR depicts a worst-case scenario. Based on the past two years’ returns and within a 95 percent confidence level, PBP can be expected to lose 1.12 percent on a bad day. Compared to SPY, with a daily VaR of 1.44 percent, PBP appears less risky than holding the index portfolio outright.
A final comparative metric, M-squared (M2), depicts the fund’s risk-adjusted return. Simply put, M-squared estimates what the fund would return if it took on the same level of risk as its SPY benchmark. PBP would have earned 3.82 percent—86 basis points more than its actual total return—if it was as volatile as SPY. If the M-squared return was lower than the fund’s actual return, the PBP portfolio would be more risky than the benchmark.
So what about income? PBP boasts a dividend yield more than twice as high as SPY’s. Still, the buy-write fund’s total return is just a third of the level of the index fund—testimony to the effect of having assets called away as the market rose prior to leveling off.
Another ETF based on the S&P 500, the Horizons S&P 500 Covered Call ETF (NYSE Arca: HSPX), pursues a more aggressive call-writing strategy. HSPX sells out-of-the-money options, which, all else equal, typically produce less income. The fund, however, writes more calls than PBP—up to 100 percent of each stock position. This affords more equity upside. But there’s a trade-off for this—namely bigger drawdowns and a higher VaR compared to PBP. Despite the risk disparity, both funds earned the same M-squared return over the past two years. Chart 1 depicts the day-to-day performance of the buy-writes versus the SPY benchmark.
First Trust Advisors runs two actively managed buy-write portfolios, one geared to maximize income, the other designed to minimize volatility. The First Trust High Income ETF (Nasdaq: FTHI) relies on a universe of large-cap stocks paying high dividends to underlie its call writing and rewards its investors with an attractive total return and dividend yield. The cost for this is higher risk, reflected in all three metrics: drawdown, VaR and M-squared.
A sibling fund, the First Trust Low Beta ETF (Nasdaq: FTLB) writes calls on the same portfolio as FTHI, but also buys put options to reduce volatility. The put premiums create a drag on performance, reducing both total return and dividend yield, but pay off with lower drawdowns and VaR compared to FTHI.
Yet another actively managed portfolio, the AdvisorShares STAR Global Buy-Write ETF (NYSE Arca: VEGA), is even more expansive. A fund of funds, VEGA is presently made up of equity sector ETFs and bond ETFs in addition to broad-based ETFs like SPY and the iShares MSCI EAFE ETF (NYSE Arca: EFA). The extensive call-writing base hasn’t produced capacious returns or dividend yields, though.
A fund that writes puts rather than calls is a standout, but not in a good way. The ALPS US Equity High Volatility Put Write ETF (NYSE Arca: HVPW) selectively sells out-of-the-money puts on high-volatility large-cap stocks, aiming to maximize income. HVPW succeeds on that front. Its dividend yield is high, but volatility torpedoes the fund on a total return basis. HVPW, in fact, is the only ETF surveyed that produced a negative total return over the past two years.
One other ETF requires special attention. Rather than being focused on the large-cap stocks populating the S&P 500, the Recon Capital NASDAQ 100 Covered Call ETF (Nasdaq: QYLD) buys the stocks populating the Nasdaq-100 Index, a compendium of the largest nonfinancial issues listed on the Nasdaq marketplace. As you can see in Table 2 and Chart 2, QYLD shows the dramatic trade-off between total return and dividend yield. Compared to the PowerShares QQQ ETF (Nasdaq: QQQ), a portfolio that tracks the Nasdaq-100, QYLD produces a much bigger dividend yield, but a significantly lower total return. The risk metrics of the QYLD fund show the benefit derived from call writing.
The Bottom Line
Call-writing funds more often than not compensate for their relatively low returns with high dividends, making up for losses incurred over the past two years. Most of the funds, too, mute market volatility, providing higher risk-adjusted returns.
Put writing, though, has been a vexation. The hefty premiums received for put sales just couldn’t cover the capital losses incurred as the options were assigned.
Investors looking for high levels of current income and hedged exposure to the equity market might very well find call writing funds attractive alternatives in a flat-to-slightly bearish market. If, however, an investor or advisor believes stocks are poised for another sustained upward surge, less costly and mechanically simpler exposures are more suitable.
 Another ETF, the ALPS Enhanced Put Write Strategy ETF (NYSE Arca: PUTX) also pursues a put-write strategy, but was only launched in 2015, making it too young to include in our two-year study.