Covered Call Funds Resurrected QWAFAFEW Presentation Boston, MA 3/15/2005 Stuart J. Rosenthal, CFA 1
Disclaimer The views I express here today are my own and do not reflect the views of Credit Suisse First Boston or its management. 2
Background First introduced in the late 1970 s, option-income funds were marketed to investors seeking income in a declining or trend-less market Their main feature was to generate income by selling covered calls against long stock or index positions With the onset of the great US bull market in 1982, they all but disappeared within a few years as most investors favored capital gains and performance suffered Recently rebranded as covered call funds, they ve staged a remarkable comeback in the US 3
Timeline 1973 Black-Scholes option pricing model [Black & Scholes] 1973 CBOE begins trading listed call options 1977 CBOE begins trading listed put options 1977 Gateway Fund -- the oldest and largest option income fund -- is launched early1980s? Colonial Option Income Trust & Putnam Option Income Trust I & II are launched 8/12/1982 With the S&P 500 at 102.42, the great US bull market of the late 20 th century begins 2002 CBOE launches the BuyWrite Monthly (BXM) Index 2004-05 Several new covered call, closed-end funds begin trading (Madison/Claymore, 1 st Trust, Eaton Vance, Nuveen) 4
The Covered Call Strategy By selling a call option against an existing long stock, an investor is paid a premium and is obligated to sell the stock at the strike price should the stock close higher than the strike upon expiration If the stock closes below the strike at expiration, the option expires worthless and the investor remains long the stock while pocketing the option premium 5
Payoff for a Covered Call % Ret Maximum Ret Option Premium Strike Stock price when option was sold Upside risk is capped Downside risk remains offset by option premium 6
Building a Covered Call Fund Long a portfolio of stocks and/or an index Sell equity or index calls against a fraction of the underlying Strike Price is usually Out-of-the-Money (OTM) Maturity is usually 1-6 months Not fully written which allows for some capital appreciation Some strategies call for the purchase of put contracts in order to protect the downside Possible to instead sell put or strangles in order to realize greater income Selling call options will reduce the portfolio s beta Buying (selling) put contracts will reduce (increase) the portfolio s beta 7
Managing a Covered Call Fund Option holdings may be rolled prior to expiration At expiration, an ITM option will be automatically sold at the strike price May wish to reinvest the proceeds at a higher price At expiration, an OTM option will be worthless Can choose to sell new calls or sell the underlying position Rebalancing prior to expiration can be tricky Selling a covered, runaway stock obligates you to repurchase a short, high delta call Tax Considerations Equity option profits are taxed as short-term capital gains Index option profits are taxed 60/40 long/short term gains Dividends 8
Beta is Negatively Correlated with Market Performance 1200 1180 1160 1140 1120 1100 S&P 500 2004 ElectionRally 1080 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 Madison/Claymore 1st Trust / Fiduciary EV Enhanced EI Nuveen Eq Prem BXM Index Beta - 20 Day Historic 8/30/04 9/12/04 9/25/04 10/8/04 10/21/04 11/3/04 11/16/04 11/29/04 As of 12/2/2004 9
A Closed-End Structure? Early funds, including Gateway Fund, were open-end structures NAV and market value are equivalent Latest offerings are closed-end structure introducing the perennial premium/discount anomaly Post-IPO support Quality and consistency of distributions [Wang] Systematic risk 10
The Premium (Discount) of Covered Call CEFs is Negatively Correlated with Market Performance 1200 S&P 500 1180 1160 1140 2004 ElectionRally 1120 1100 1080 6 4 2 Madison/Claymore R^2=-0.68 % Premium (Discount) to NAV 0-2 1st Trust / Fiduciary -4 R^2=-0.51-6 8/30/04 9/12/04 9/25/04 10/8/04 10/21/04 11/3/04 11/16/04 11/29/04 As of 12/2/2004 11
The Premium (Discount) of Covered Call CEFs is The Premium (Discount) of Covered Call CEFs is Inversely Related to Market Performance Negatively Correlated with Market Performance % Change in Fund's Premium 3.0 2.0 1.0 0.0-1.0-2.0 EOI (since 12/9/2004) R 2 = 0.38 MCN (since 8/30/2004) R 2 = 0.21 FFA (since 10/6/2004) R 2 = 0.28 As of 12/21/2004-3.0-3.0-2.0-1.0 0.0 1.0 2.0 3.0 4.0 S&P 500 Daily % Change 12
Performance Attribution Performance of the long holdings Implied volatility of the short calls Other important factors Contract Maturity Interest Rates Utilization (% of the portfolio that is hedged) Liquidity Moneyness (e.g. 10% OTM) of the options Market Capitalization Roll philosophy 13
Covered Call Funds Alter the Returns Distribution Tighter Returns 16 14 12 Hedged UnHedged % Frequency 10 8 6 4 2 0-17.5-12.5-7.5-2.5 2.5 7.5 % Total Return 12.5 17.5 22.5 Smaller Tails 14
Issues with Covered Call Funds Arbitrarily selling covered calls might be interpreted as selling shares, raising cash, or reducing risk Properly valued options are priced to be risk-neutral and arbitrage-free [Black, Scholes] Strategy can be sub-optimal to a utility-maximizing investor To add alpha, consider selling options when implied volatility is consistently higher than realized volatility [Rendleman] What about stock selection skill? Upside potential is capped Consider underweighting those positions with poor alpha forecasts 15
Call Overwriting with Index Options Can add value since implied volatility usually overestimates actual volatility Jumps to the upside are rare BXM Index uses a buy-write implementation S&P 500 long position 100% short sale of the front-month, ATM index call Since 1988, BXM has roughly matched the performance of the S&P 500 Total Return with only 2/3 the risk [Feldman & Roy] 16
VIX has overstated S&P 500 realized volatility 88% of the time 40 VIX Index 30 % Annualized 20 10 0-10 VIX - 30 Day Realized Volatility -20 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 17
Call Overwriting with Equity Options Implementation is more difficult Frequent jumps to the upside are problematic (e.g. announced takeover, positive earnings, etc.) Idiosyncratic risk leads to higher implied volatility levels than index options Passively selling equity call options will typically underperform the long-only (unhedged) portfolio For the period 1994Q4-2004Q3, overwriting 25% of each stock in the S&P 100 with an ATM, 3 month call option would have underperformed by 95 bpts and added 258 bpts in tracking error [Balasubramanian and Tierens] Realized volatility is usually underestimated by implied volatility 18
Monte Carlo Simulation of an S&P 100 Index Call Overwriting Strategy Long each S&P 100 constituent holding Sell nearest OTM equity call option against 65% of each stock 3 month maturity 20.7% implied volatility, wtd average, 12/3/2004 Div yield=1.92% If assigned at expiration, repurchase fewer shares at the spot price. At expiration, new short sale against each long holding Pure martingale approach no drift component for any stock 19
Call Overwriting in the Face of Rising Interest Rates Call options have positive Rho Higher interest rates warrant higher call prices Yet, the portfolio s Rho is significantly < 1 Strategy is less attractive when rates rise 20
Rising Interest Rates Render Covered Call Funds Less Attractive Option Income % 6 5 4 3 Rho (slope) = 0.18 95 % Confidence Bands 2 0 1 2 3 4 5 6 7 8 9 10 11 3 Month Interest Rate % 21
Contract Maturity What is the optimal maturity? Inflection point using 3 Month options Liquidity concerns Theta decay Income considerations Highest theta associated with 1 Month options will not always improve option income performance Contract maturity should match the minimum holding period of the long position Option overlay will otherwise constrain stock rebalancing 22
Total Return % Alpha Relative to Unhedged Portfolio 8 6 4 2 0-2 -4-6 -8 6 Option Income % 5 4 3 2 1 2 3 4 5 6 7 8 9 10 11 12 Contract Maturity (Months) 23
Implied Volatility The implied volatility of each option will directly impact performance Higher volatility increases the value of call & put options Implied volatility is negatively correlated with market/stock performance A rising market will generally reduce implied volatilities and associated option income 24
Higher Implied Volatilities Will Improve Option Income Performance 9 8 Vega=0.35 7 Option Income % 6 5 4 3 2 1 0 14 16 18 20 22 24 26 28 30 Portfolio Implied Volatility % 25
But Implied Volatility Depends on Index/Stock Performance VIX Monthly Change (Vol Pts) 15 10 5 0-5 -10 1990 - - 2004 R-Squared=0.43-15 -15-10 -5 0 5 10 15 S&P 500 Monthly % Ret 26
Utilization How much of the notional portfolio to overwrite? Important tradeoff between option income and capital appreciation Decrease the hedge for those stocks/sectors with the highest alpha scores 27
8 6 4 2 0 6 4 2 0-2 -4-6 -8 Utilization Rates Will Impact Performance 100 % Utilization 75 50 25 100 % Utilization 75 50 25-25 -20-15 -10-5 0 5 10 15 20 25 Unhedged Portfolio % Tot Ret 28 Hedged Port % Alpha Hedged Port % Tot Ret Alpha _ Option % Income _ Option % Income
Best Practices for Covered Call Funds Avoid the asset class if expectations are for a higher stock market in short / intermediate term Baseline strategy may employ a core-satellite approach, 50% hedged with 3 month index call options Minimizes the jump risk, ride the winners & sell the losers Can add alpha since index options are usually overpriced Increase (decrease) the hedge if near term expectations are for a lower (higher) market Consider 5% OTM, 3 month, BXM-like approach For the 1990-2002 period, strategy outperforms the S&P 500 by 108 bpts with ¾ the risk [Hill & Gregory] 29
Best Practices (cont.) Selectively sell equity call options Disciplined stock sell strategy Calls are rendered overpriced Alpha enhancement Maintain a minimum portfolio Beta Consider a short (long) variance swap if the call is deemed overvalued (undervalued) Pure bet on volatility Outsourced delta-hedging program Does not change stock exposure Easier to decipher option income performance 30
Best Practices (cont.) When selling equity calls, give preference to largecap, growth stocks Higher volatility Lower dividend yield Better stock & option market liquidity Lower takeover risk Avoid the purchase of expensive put options In a down market, you will usually outperform anyway Consider the purchase of cheap, longer-dated, 7.5--10% OTM Index calls if odds favor a rally If the market rises, portfolio s beta will otherwise decrease 31
Covered Call Funds: The Bottom Line In the long run, strategy can not succeed as a pure play on income Coupon is far from stable Return of capital risk A higher interest rate environment offers better alternatives Need to maintain some price appreciation potential, especially in a rising market The best scenario is a sideways, mean-reverting market Up markets will cap returns, and cause regret Down markets may still render negative absolute performance If managed properly, can succeed as a yield enhancement or growth & income product 32
References Balasubramanian, V. and I. Tierens, Stock Option Selling Strategies Can Generate Alpha Even in a Flat and Skinny Market, Goldman Sachs Index and Derivatives Perspective, Oct 2004, 62-83 Black, F. and M. Scholes, The Pricing of Options and Corporate Liabilities, Journal of Political Economy, 81 (May/June 1973), 637-59 Feldman B. and D. Roy, Passive Options-based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index, Ibbotson Associates, July 28, 2004 Hill, J. and K. Gregory, Covered Index Strategies: Appealing features for Total Return or Income-Oriented Equity Investors, Goldman Sachs Index and Derivatives Perspective, Oct 22, 2002, 19-35 Rendleman, R. Jr., Covered Call Writing from an Expected Utility Perspective, Journal of Derivatives, Spring 2001, 63-75 Wang, Z.J., Managing the Discount: The Distribution Policy of Closed- End Funds, Department of Finance, University of Michigan Business School, Mar 2003 33