For investors examining their arsenal for different ways of gaining exposure to US stocks, we have another possible arrow for the quiver: buy-write strategies. With domestic equities in their ninth year of a bull market—not to mention S&P 500’s 11.9% gain in 2016—it is likely time to acknowledge strategies that have the potential to arm investment portfolios with the wherewithal to withstand different economic landscapes. As we inch closer to the 10-year anniversary of the largest financial collapse since the Great Depression, it is vital to remember that times ahead may be challenging. While we do not necessarily anticipate an impending correction in the market, investors must recognize that increased volatility may eventually return.
Buy-write is an investment strategy that involves taking ownership of a security and then selling options on that same security. It is often called ‘covered’ options writing because you own the security you are writing the options contracts on. Those in the covered-call market believe that market participants overpay for insurance. This philosophy combines a belief that an underlying security will likely not move significantly in price, with the notion that an option-writer can effectively increase income by harvesting over time the premium on the call option. Meanwhile, owning the security protects against downward price volatility and reduces the downside risk of writing the option.
These strategies are expected to outperform in risk-averse markets by providing alpha generation through capturing premiums on the option. The inherent disadvantage of this strategy is that the upside price movement is capped at the strike price of the option contract, preventing the strategy from completely participating in steady growth markets.
If one anticipates an uptick in market volatility, actively-managed covered-call strategies have the potential to cap downside volatility while participating in rising markets over full economic cycles. The key to interpreting performance in the covered-call space is evaluating a strategy over a full market cycle. Due to the nature of the approach, short-term periods of underperformance are to be expected, especially during times of low volatility. While investors in these strategies can expect additional returns from the income generated through the premiums, these approaches are typically used as a way to reduce volatility in the portfolio’s equity allocation. Successful buy-write investments have the potential to meet or exceed returns of the S&P 500 index over a market cycle of seven-to-10 years, according to our preliminary analysis of covered-call strategies in the eVestment universe. That being said, it is difficult to evaluate any single approach to buy-write strategies due to their relatively short history.
It is important that clients are comfortable with the long-term commitment required to fully realize the risk-return potential of these strategies. Given the potential range of outcomes over any given short-time period, these investments are suitable for clients who are comfortable with committing their capital for up to 10 years. Therefore, these strategies may not make sense for all types of investors and consultants must weigh their benefits and drawbacks before implementation.