By design, exchange traded funds adhering to buy-write or covered call strategies will be laggards in strong bull markets.
That is the price investors pay for reduced volatility and added income. The PowerShares S&P 500 BuyWrite Portfolio (NYSE:PBP) is a case study in this phenomenon. Over the past three years, the PowerShares S&P 500 BuyWrite Portfolio is up 15.8 percent, less than a third of the 48.5 percent returned by the SPDR S&P 500 ETF (NYSE:SPY) over the same period.
However, choppy, sideways and even turbulent market environments, such as the one investors are currently contending with, provide opportunity with covered call ETFs, including PBP.
If such sideways conditions persist, we are likely to experience higher levels of equity volatility and higher sustained risk premiums. I believe this will make call-writing strategies more important than ever as an option for sourcing income and supplementing dwindling equity market returns. Remember, as equity market volatility increases, option risk premiums increase, which in turn can increase the amount of income call writers are able to generate, according to a new note from PowerShares. If one expects the US equity market to continue along in the same choppy fashion failing to break out strongly to the upside or downside, a covered call strategy could be especially attractive.
Although writing covered calls implies an element of active management, PBP is a passive, index-based ETF. The $322.1 million fund tracks the CBOE S&P 500 BuyWrite Index, a benchmark designed to track the performance of a hypothetical 'buy-write' strategy on the S&P 500, according to PowerShares, the fourth-largest U.S. ETF sponsor.
Looking at the equity portion of PBP's lineup, investors will see an ETF that looks just like a traditional S&P 500 Index fund. However, PBP's perks come with some cost as the fund charges 0.75 percent per year, well above the expense ratios found on standard S&P 500 ETFs.
What PBP offers investors is a long S&P 500 with covered calls written at strikes that are at and above the index's current trading price. Premiums received from the sold options are reinvested. PBP's yield advantage over the S&P 500 is significant. The trailing 12-month dividend yield on the benchmark U.S. index is 1.92 percent, well below the 3.3 percent found on PBP.
In bull markets, covered calls give away a portion of the markets appreciation in return for the income generated by the option premium. However, recent equity markets have struggled to move higher as they digest declining global growth expectations which could benefit covered call strategies. Year to date, the S&P 500 Index is up only 0.73%, including dividends held in check by the headwinds of Chinas recent currency devaluation, sputtering economic activity in emerging markets and Europe, and the effect of the strong dollar on US corporate earnings, said PowerShares.
What is important is that PBP does its job when market environment dictates the time could be right for such a fund. Sometimes that means being less bad than a regular S&P 500 ETF and that is exactly what PBP has been this year. Year-to-date, the covered call fund is down 2.9 percent compared to a 6.1 percent decline for the S&P 500.
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