Key Observations
- Bonds have historically provided and can continue to provide true diversification to equity portfolios.
- Traditional monthly covered call strategies, while offering income, have not delivered the total return of equities nor provided any significant diversification benefits.
- With the innovative use of daily options in covered call strategies, investors can now generate substantial income while still capturing more equity-like total returns. They can potentially have a better balance between income generation, total return, and risk management in their portfolios.
A New Approach to Equity Income
Covered call strategies have become very popular with income-seeking investors. However, traditional monthly covered call strategies come with a costly trade-off, as their income-producing features may sacrifice much of the total return of the underlying equities. Covered call strategies using daily options offer an innovative solution to this shortcoming.
Some investors acknowledge the trade-off in total return, believing that traditional monthly covered call strategies can reduce equity risk. Unfortunately, these strategies have neither delivered the total return of equities nor provided any meaningful diversification benefit.
This insight—that traditional covered call strategies may impair investors’ total return while failing to add portfolio diversification—is critical for investors seeking growth and income. In this article, we will demonstrate how the use of daily options within a covered call strategy has the potential to generate substantial income while also targeting the total return of equities. In addition, we will illustrate how bonds have historically added—and can continue to add—true diversification to equity portfolios.
Part 1: The Covered Call Conundrum
Covered call strategies have become popular because they generate significant yields in the form of monthly premiums. These are relatively simple strategies in which a trader sells a call option while simultaneously owning the underlying stock or index, earning a premium. The downside to this approach is that it limits much of the upside potential of the underlying assets, which can be substantial over time. Over the last ten years the Cboe S&P 500 BuyWrite Index (BXM)—a benchmark for a traditional monthly covered call strategy—has delivered only one-third the return of the S&P 500.
Many income-minded investors console themselves with this trade-off by assuming, or expecting, that a covered call strategy will reduce the risk of their equity exposure. This is not necessarily the case, as this article will demonstrate.
To illustrate how covered call strategies might perform during times of market stress, we can test three different hypothetical portfolios during the Global Financial Crisis (GFC).
- Portfolio 1 represents a baseline 60% stock/40% bond portfolio.
- Portfolio 2 assumes an investor "had a feeling" before the GFC that things were going to get bad, and decided to adjust their 60/40 allocation by moving an additional 20% out of stocks into bonds.
- Portfolio 3 reflects shifting 10% each from the stocks and bonds in the hypothetical Portfolio 1 into a covered call index, resulting in a 50% stocks/30% bonds/20% covered call allocation.
Hypothetical Performance of Global Financial Crisis Portfolio
Source: Bloomberg. Data from 10/01/07 – 03/09/09. Global Financial Crisis hypothetical portfolio allocations: Portfolio One—60/40, Portfolio Two—40/60, Portfolio Three—50/30/20. All hypothetical portfolios assume quarterly rebalancing. They are constructed using the following indexes: S&P 500 Total Return Index, ICE BofA 7-10 Year US Treasury Bond Index and CBOE S&P 500 BuyWrite Index. These indexes are used throughout this paper to represent performance of stocks, bonds and a monthly covered call strategy. Outcomes shown are hypothetical in nature and actual performance may have differed significantly from the results shown. Hypothetical results are based on criteria applied retroactively with the benefit of hindsight. Past performance does not guarantee future results.
While adding more to bonds helped significantly, adding covered calls did not make a material difference during this period. The portfolio that included 20% in covered calls—Portfolio 3—lost 34.6%, worse than the 31.7% loss experienced by the traditional 60/40 portfolio (Portfolio 1). In contrast, the portfolio that increased its bond allocation, reversing the standard 60/40 to a 40/60 mix, lost only 19%, a substantial reduction of about 40%.
Part 2: How Stock/Bond Correlation Can Change Over Time
One of the most popular assets to pair with stocks is bonds, both corporate and government. This is due to the typically low, and often negative, correlation that bonds exhibit relative to stocks.
As we saw in the previous illustration, while the Global Financial Crisis (GFC) was an excellent example of this diversification benefit, it also led the U.S. Federal Reserve to institute Quantitative Easing (QE). Historically, when economic conditions deteriorate and equity prices fall, bond yields fall, and bond prices rise—hence a negative relationship. However, the massive asset purchases associated with QE suppressed the yields on longer-term Treasurys, leaving little room for this behavior. As a result, QE broke down the historically negative relationship between stocks and bonds.
This shift in correlation can be observed by comparing the returns of the S&P 500 and the ICE BofA 7-10 Year Treasury Index from two periods—one before and one after the inception of QE. The scatterplots from these periods that follow clearly show a dramatic shift from a negative to a positive relationship between the two assets.
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