HIGHER INCOME WITH LESS VOLATILITY: STRATEGIES FOR BOOSTING SHARE INCOME

Transcription

1 A BetaShares Educational Whitepaper In a declining interest rate environment, and with ongoing concern about risk in the equity markets, investors are finding it increasingly difficult to rely upon traditional exposures to cash, bonds or equities to deliver adequate income with reasonable levels of volatility. Income from shares strategies range from the simple (buy high yielding shares like Telstra, or the banks, and collect dividends) to the more sophisticated (buy shares, collect the dividends and generate additional income through the sale of some of the upside price potential). To implement this latter strategy, an investor buys a share (or share portfolio) and simultaneously sells or writes call options on the relevant shares. By selling call options, the investor is selling to the buyer of the option, the right to buy the relevant share from the investor at a certain exercise price. The seller of the call option receives a fee (income) for doing so. This form of equity income or buy-write strategy is well established in investment practice and is especially popular when markets are sluggish or trending sideways 1 : From the perspective of the owner of shares who sells call options over them (and receives a fee for doing so), this fee supplements the dividends on the underlying shares; potentially providing a significant boost to the income on those shares. Looked at another way, the fee subsidises the purchase price of the share, effectively lessening its cost; thereby reducing the risk of holding the share. From the perspective of the buyer of the call option (who pays a fee for doing so), the call option can be used as a way to obtain exposure to the potential upside of a share, with a smaller outlay than would be required to purchase the share directly. This is because the call option gives the holder the right to buy the share for a preset price within a stipulated time frame see breakout box over the page). Strategies aimed at generating income from shares are very popular when markets are sluggish or trending sideways Buy-write strategy involves buying shares and then generating additional income through the sale of some of the upside price potential of the shares An easy way to think of this strategy is that it allows the shareholder to pre-sell some of the future capital gain potential on the share/s and to receive payment immediately for doing so. Even better, if the share doesn t rise during the period of the option, or rises but only to a point below the price at which that investor has agreed to sell the share, the income received by the investor will have been earned without any impact on the shareholding itself. When carefully managed, the buy-write approach can be a powerful income booster, but the problem for even sophisticated private investors is that the strategy can be timeconsuming, costly and difficult to implement. Until recently, the only alternative to implementing such a strategy directly (which can be complex and expensive), has been for investors to buy a traditional actively managed fund that implements such a strategy. Of course, investing in such a vehicle carries risk that the active options trading implemented by the fund manager can go wrong. Such a fund also typically will come with relatively high management fees and, often, performance fees. With the GFC still seared in our collective psyche, many investors will be attracted to a simpler way of obtaining access to such an equity income strategy. The BetaShares Equity Yield Maximiser Fund 2 (ASX code: YMAX) is an ASX-traded investment product that holds the 20 largest ASX listed securities, and uses a rules-based approach to sell (or write ) exchange-traded call options over these securities. With an annual management fee of 0.59% pa (plus expenses capped at 0.20% pa), YMAX is a lower cost alternative to traditional actively traded managed funds offering similar strategies. Buy-write approach can be a powerful income booster, but has traditionally been costly and difficult to implement YMAX fund uses a rules-based approach and gives investors a simple, low cost way to obtain access to an equity income strategy 1 In some literature, this strategy is also referred to as a covered call strategy. In this paper we will refer to this strategy as an equity income strategy 2 BetaShares Australian Top 20 Equity Yield Maximiser Fund (managed fund) 1

2 What are call options? A call option gives the buyer of the option the right but not the obligation to buy an asset (eg a share) at a preset price, within a stipulated future time. In return for being granted that right, the option buyer will pay a fee to the option seller. The preset price is known as the strike price or the exercise price. The option fee is known as the option premium. Having sold a call option, the seller can be called upon to sell the share at the strike price, should the share price be above that level at or before expiry of the option term. Call options can be set with strike prices which are above or below the current share price, or at the same level as the current share price. Strikes which are: above the current share price are known as out of the money below the current share price are in the money equal to the current share price are at the money. ASX Research The performance of strategies of the type employed by YMAX has been the subject of significant academic and empirical research. In August 2012, the ASX released a research paper which examined the risk and return characteristics of various equity income strategies using options for stocks traded on the ASX. The strategies examined use some relatively simple rules which can guide effective equity income investing without the need for active trading in options. Performance of equity income strategies subject to landmark ASX research in 2012 In light of increased scrutiny over investment strategies and products, it s critical for investors to understand the risks and returns of equity income buy-write strategies. The ASX research (summarised in the chart below) uses actual data for 30 blue chip stocks over the pre- and post- GFC period and shows that using the covered call approach added a total of between 20% to 60% to basic share returns between April 2005 and December Since the period covered by the ASX research covered 3 very different parts of the investment cycle (the pre GFC bull market, the severe collapse in the GFC, and the patchy recovery from the GFC), it is compelling reading for investors interested in the buy-write approach. In summary, the ASX research (see Figure 1 below) confirms that share returns were improved using equity income investing strategies in each of these 3 very different market environments and importantly, that it continued to add value all the way through the worst of the GFC. ASX study confirms that share returns were improved using equity income investing strategies over 6.5 year period FIGURE 1: RESULTS OF THE ASX RESEARCH - PERFORMANCE OF VARIOUS BUY-WRITE STRATEGIES V UNDERLYING STOCK PORTFOLIO (APRIL 2005-DECEMBER 2011) Source: ASX Market Insights, An Encyclopedia of Australian Buy-Write Returns (August 2012). Past performance is not an indicator of future performance. 3 The full study is available on the ASX website at als/buy_write_encyclopaedia_august_2012.pdf. Past performance is not an indicator of future performance. 2

3 The ASX research was conducted by one of Australia s premier finance think tanks, SIRCA, an independent financial research body and a collaboration between a number of Australia s top universities. The research examined a number of different rules-based equity income strategies using actual/real data for share and option prices during the period. ASX research examined a number of rules-based equity income strategies The approaches assessed by SIRCA used a simple strategy of an investor holding physical shares and selling ASX exchange traded options ( ETOs ) with a term or maturity date of one month, and with a variety of exercise prices and implementation strategies. Because the approach is based on the investor also holding the same number of stocks as it sells the call options over, the strategy is fully hedged, and hence is known as covered call writing (compared to not holding the same number of shares or holding none at all which is riskier and is known as naked call writing). Understanding the ASX Research One of the main benefits of the ASX research is that it analyses a variety of mechanical or rules-based approaches to implementing an equity income strategy using options. This provides a useful guide as to how such strategies can be implemented without the need to actively trade the option and equity positions. As noted above, because of the relative complexity and time-consuming nature of implementing such strategies, retail investors have typically been forced to buy into active trading funds to gain exposure to similar strategies or to use a broker to actively trade and manage the position/s for the investor. Active option trading may produce good returns but also creates the risk that the trader/ fund manager may not consistently achieve the benefits that a cheaper, lower-turnover, rules-based approach can potentially deliver. As the ASX research states: Traditional active funds applying equity income strategies may expose investors to the risk that the fund manager may not consistently achieve the benefits that a rules based approach can potentially deliver Performance will differ if the investor takes subjective assessments of such trades into the buy-write decision making process. 4 Using a broker, instead of an active fund manager, to implement these strategies also involves subjectivity (and potential for variability of returns) and generally requires a large investment. Prudent brokers require that a diversified portfolio be held as the hedge for the call positions (often up to 10 different stocks). Because option selling also involves brokerage costs (around 1% for each option trade), it is typical for the broker to require a minimum of $50,000 worth of each share to be held as the hedge for the options writing. So using a broker to implement equity income strategies using options may be impractical for all but the wealthiest of retail investors, especially if there is active trading of the option positions (thereby increasing brokerage costs). The ASX research also highlights the core benefits of the buy-write approach ie, ignoring the risks or rewards that can be generated by active trading funds, what are the systematic returns available from such strategies in and of themselves? To answer this question and to compare the outcomes from a variety of different approaches, the ASX research considered 6 differing rules-based methodologies (each using a standard list of the top 30 shares listed on the ASX) and compared the results to the share portfolio itself (e.g where no buy write strategy was utilised) ASX research compared 6 rules-based methodologies and compared the results to the share portfolio itself 4 Jarnecic, Flint and Lim: An Encyclopedia of Australian Buy/Write Returns (ASX, 2012, p. 2) 3

4 Results of the ASX Research The full results for each of these strategies is set out in the ASX research paper. The data and analysis is shown for each of the 30 stocks analysed and also for the overall portfolio. In summary, however, this paper demonstrated that share returns were improved using equity income investing strategies over the six and a half year study period. In fact, over the period of the study, each of the various equity income strategies examined generated a higher risk-adjusted return relative to a long-only stock portfolio: Each of the various equity income strategies examined in the ASX research generated a higher risk-adjusted return relative to a long-only stock portfolio Table 1 below shows more detailed data regarding these results. FIGURE 2: ASX RESEARCH RESULTS DATA Stocks Only Basic Equity Income (Buy Write) Strategies Sell Momentum Volatility Delta signal Source: ASX Market Insights, An Encyclopedia of Australian Buy-Write Returns (August 2012). Past performance is not an indicator of future performance. Significantly the ASX research shows that: the overall performance of the underlying share portfolio was essentially flat to negative in the 6 year period between 2005 and 2011 (something that many investors will personally have experienced); the average outperformance of the strategies examined was ~4% pa over and above the return of the underlying share portfolio; The average outperformance of the equity income strategies examined was ~4% pa over and above the return of the underlying share portfolio each of the strategies examined also reduced the variability of returns (risk) on the portfolio on average the strategies examined reduced the minimum monthly return on the portfolio from % to approximately -37% and also reduced the maximum monthly return from 15.14% to approximately 8%; on average the strategies examined changed the ratio of Up months to Down months from 49:51 (for the underlying share portfolio) to 52:48 So the conclusion arising from the detailed ASX research is that buy-write strategies can add meaningful benefits to share portfolios. 4

5 What this means for investors Interested investors can use the ASX paper as a reference for their own trading strategies noting of course the general risks of sharemarket investing (although as noted above, consider strategies using buy-write methodologies as a way of subsidising share investing). As always, take advice if you are unsure of any aspect of buy-write strategies. Exchange traded options are the most liquid and readily available options over ASX listed shares and they are backed by a central clearing house and the experience of the ASX options market (the second oldest stock option market in the world). Let s now look at some of the specific risks that need to be considered and carefully managed when using such equity income strategies. Risks of buy-write investing In the case of buy-write investing, the investor s risks include: 1. The share price falls (but because the investor will generate cash by selling the call options and receiving the option premium, the downside risk is less when calls are sold than it would be if the shares were held outright); Key risks of buy-write investing relate to the price of the shares in the underlying stock portfolio 2. The share price rises above the strike price of the call option. In this scenario the investor will still receive some gain on the underlying share, but that gain will be capped at the level at which the call option is exercised. Actual returns may be impacted by market volatility and liquidity. Typically, buy-write strategies can be expected to outperform a stock-only portfolio in certain market environments namely: Outperform in a modest bull market Outperform in a range bound market Outperform in a bear market However - as buy-write strategies involve forgoing some of the return from the price appreciation of the relevant securities, such strategies can be expected to underperform in a strongly rising market. The BetaShares YMAX Fund For investors who prefer to utilise an external investment manager to implement a rulesbased equity income strategy, who like the convenience of an ASX-traded fund and who are wary of investing with expensive active trading funds, BetaShares provides the Equity Yield Maximiser Fund (ASX code: YMAX). YMAX was launched on the ASX on 26 November YMAX uses a rules-based process to sell call options over up to 100% of the ASX 20 stocks, to seek to generate additional income and reduce risk. YMAX key features are: YMAX fund uses rules to determine how and when to sell call options over the largest 20 ASX stocks Simple rules-based approach in which the Fund holds the top 20 Australian shares and then seeks to sell call options over individual shares in the share portfolio Low cost (0.59% pa management fee + expense recovery 0.20% pa max) Physical stocks are held in YMAX all dividends and franking credits are passed through to investors Rules-based process for buy-back of options where underlying share price has rallied (eg to address call away risk) Only ASX Exchange Traded Options (ETOs) are used - reducing counterparty risk Passive stock portfolio and rules-based option strategy minimising trading costs and improving tax efficiency Quarterly distributions and availability of a distribution reinvestment plan (DRP) Eligible for SMSF use Investment is a unit in a managed investment scheme (ie not a derivative) Lonsec research available 5

6 The strategy utilised by YMAX combines elements from the different buy-write strategies examined in the ASX research, along with some modifications that seek to optimise the strategy (as a result, YMAX s strategy is not identical to any particular strategy described in the ASX research, and the past performance described in the ASX research is not indicative of the future performance of YMAX). For more information on YMAX, see www. betashares.com.au. Paper prepared by: Tony Rumble, PhD Head of Portfolio Construction, BetaShares tony.rumble@betashares.com.au Trading Information BetaShares Funds can be bought or sold throughout the trading day on the ASX, and trade like ordinary shares. EXCHANGE ASX CODE CURRENCY TRADING BLOOMBERG CODE IRESS CODE Fund Information ASX YMAX AUD 10:00-16:00 (AEST) YMAX AU YMAX.AXW ISSUER BetaShares Capital Ltd FUND ADMINISTRATOR FundBPO CUSTODIAN RBC Investor Services AUDITOR PricewaterhouseCoopers DISTRIBUTIONS Quarterly MANAGEMENT FEE 0.59% p.a EXPENSES capped at 0.20% p.a FUND INCEPTION 22 November 2012 About BetaShares BetaShares is a specialist provider of fund products that are traded on the Australian Securities Exchange. Our objective is to expand the universe of investment possibilities for investors in Australia. BetaShares is part of the Mirae Asset Global Investment Group, one of the largest asset managers in Asia. Currently, Mirae manages over US$50B, including over US$5B in the Horizons family of ETFs. T: (Australia) T: (ex Australia) info@betashares.com.au Important: This information has been prepared by BetaShares Capital Ltd (ACN AFS Licence ), the responsible entity of the BetaShares Australian Top 20 Equity Yield Maximiser Fund (managed fund) ( Fund ). It is not a recommendation to buy units or adopt any particular investment strategy. You should make your own assessment of the suitability of this information. It is general information only and does not take into account any person s particular circumstances. Before making an investment decision regarding the Fund, investors should consider the PDS and their circumstances and obtain financial advice. The PDS is available at. Investors may buy units on ASX through a broker or financial adviser. An investment in the Fund is subject to investment risk including possible delays in repayment and loss of income and principal invested. Past performance is not an indication of future performance. The Fund s strategy is not identical to that shown in the ASX research described above and no representation is made that the Fund will achieve results similar to those shown in the ASX research. Any opinions are subject to change without notice and actual events may differ materially from those reflected in any opinions or other forward-looking statements. To the extent permitted by law BetaShares accepts no liability for any loss from reliance on this information. 6