by Max Minack
The hunt for yield in the investment world is intense, with dividend yields on global stock markets falling materially since early last year, and bond yields close to record lows.
The dividend yields on the Australian and U.S. markets have fallen drastically since the start of last year, with the S&P 500 falling from 2.3% in March 2020 to 1.28% November in 2021, and the ASX200 falling from 4.74% to 3.66% over the same period1.
However, for equity investors looking to boost their income, there is another strategy worth considering, one that has the additional benefit of reducing volatility.
The ‘covered call’ is a ‘tried and true’ option strategy that has been popular with income-seeking investors for decades. The good news is you don’t have to be an options trader to take advantage of this strategy. Betashares offers two exchange traded managed funds that employ covered call strategies on the portfolio of shares the funds hold, offering the potential for increased income without having to dive into the options market yourself.
What is a covered call?
A call option gives the buyer of the call the right to purchase the underlying shares at a set price on or before a specified date (the expiry date).
For example, a BHP January 38.00 call gives the buyer the right to buy 100 BHP shares for $38.00 any time up to and including the expiry date in January. For this right, the buyer pays the option premium, which will depend on a number of things, including the current price of BHP shares, and the length of time to expiry. In our example, let’s assume the current BHP share price is $38.00, there is one month to expiry and the option premium is $0.50 per share ($50 for the option contract).
Conversely, the seller (writer) of the option receives the premium, and in return, takes on the obligation to sell BHP shares for $38.00 if the option buyer exercises the option.
Essentially, the option writer pockets the premium generated from selling the call option whilst also still receiving dividends and franking credits (if applicable) from the underlying stock. As long as the stocks in your portfolio have options listed by the ASX, you can apply this strategy across all or most of your portfolio if you choose. This will result in higher income than the income from dividends and franking credits alone, as shown below:
Source: BetaShares. Franking credits are not applicable to international shares.
Whilst selling call options generates superior income, there is no such thing as a free lunch!
The downside for the option seller in return for the option premium is that if the stock at expiry is above the exercise price (strike price) of the option, you will have to sell your shares at below their market value. This places a cap, or limit, on the upside of the capital value of the stocks the call options are written over.
The maximum total returns a covered call writer can generate is the difference between the stock price at the time of writing the option and the strike price, plus the income generated from selling the options, and any dividends from the stock during the life of the strategy. The chart below shows the payoff at expiry for the covered call above vs. the return from simply holding BHP shares. It assumes that no dividends are paid during this time.
If the BHP share price at expiry has fallen, remained steady, or risen modestly, the covered call writer will be ahead of the ‘stock only’ investor. If BHP shares have risen significantly (above $38.50), the stock only investor will be ahead.
Compared to simply holding the stock, the covered call writer can typically expect to outperform in flat, declining and modestly rising markets, due to receiving the option premium. The covered call writer will underperform in a strong bull market, where the underlying stock’s price appreciates beyond the strike price + option premium.
The investment outcomes are illustrated below.
For illustration purposes only.
Given the investment outcomes – that significant movements in the stock price (either up or down) will be moderated by the written call – the covered call strategy typically results in reduced volatility, compared to simply holding the stock. As it limits the potential upside growth of your portfolio, it may not be suitable for growth investors, or if you hold a strongly bullish outlook.
Betashares Covered Call Funds
Betashares offers two exchange traded managed funds that employ the covered call strategy, meaning you can participate in the benefits (and risks) of the strategy without having to get involved in the options market yourself.
BetaShares Equity Yield Maximiser Fund (ASX: YMAX)
YMAX employs a covered call strategy over the 20 largest stocks on the ASX.
The fund aims to provide unitholders with:
- regular income that exceeds the dividend yield of an equivalent portfolio of 20 blue-chip Australian equities
- the potential for some capital growth, and
- lower volatility of returns than an equivalent portfolio of 20 blue-chip Australian equities.
This is shown below:
BetaShares Australian Top 20 Equity Yield Maximiser v Australia 20 Index: Income and Volatility to 29 October 2021
It is important to bear in mind that income is only one source of return when investing. Total return on investment also reflects changes in price. From a total return perspective, YMAX has returned 23.30%, 7.58% and 6.67% per annum over 1, 3 and 5 years respectively2.
BetaShares S&P 500 Yield Maximiser Fund (ASX: UMAX):
UMAX employs a covered call strategy over the S&P 500 using index options.
UMAX’s strategy is designed to provide investors with:
- broad market exposure to the S&P 500 Index (U.S. equities market)
- an attractive income yield that exceeds the dividend yield of an equivalent portfolio of underlying shares alone
- lower overall volatility than the underlying share portfolio alone
- The current trailing dividend yield on UMAX is 5.4% p.a.3
UMAX has provided a total return 26.99%, 9.49% and 11.31% per annum over 1, 3 and 5 years respectively4.
There are risks associated with an investment in these funds, including market risk, use of options risk and, in the case of UMAX, foreign exchange risk. For more information on the risks and other features of YMAX and UMAX, please see the relevant Product Disclosure Statement available at www.betashares.com.au. A Target Market Determination is also available at www.betashares.com.au/target-market-determinations.
1. Bloomberg. As at 10 March 2020 and 17 November 2021. 12 month trailing dividend yield.
2. As at 29 October 2021, net of fees. Past performance is not an indication of future performance.
3. As of 29 October 2021. Yield figures are calculated by summing the prior 12 month fund per unit distributions divided by the fund closing NAV per unit. Past performance is not an indicator of future performance.
4. As at 29 October 2021, net of fees. Past performance is not an indication of future performance.