LA Department of Water & Power Employees Retirement System Pension Consulting Alliance, Inc. Client Name/Logo December 1 2010
G rowth of $100 Considering Covered Calls RATIONALE Growth of U.S. Equities? 160 R u sse l l 3 0 0 0 In d e x 150 T o ta l 140 130 120 110 100 90 80 70 60 50 Aug-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Oct-10 (44%) loss in 25 months (51%) loss + in 16 months (70%) cumulative losses in last 9 years Heavy dependence on the public equity risk premium has caused havoc for cash-flow oriented sponsors/investors 2
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CONCEPTUAL BACKGROUND The purpose of covered calls (and many other structured strategies) is to provide some form of downside protection Key question: Does this kind of vehicle help a portfolio (i.e., improve risk-adjusted results)? Important consideration: Return distribution patterns of structured strategies (such as covered calls) are truncated and do not conform to mean-variance analysis Structured vehicles best analyzed under a simulation-based framework Goal: To develop basic insights about the usefulness of covered calls and to determine whether they should be included in the asset-liability model 4
G row th of $100 Considering Covered Calls RATIONALE Comparison of Growth Patterns Covered Calls vs. Other Major Classes 800 T o ta l 700 B X M C o ve re d C a l l S & P 5 0 0 In d e x B C A g g re g a te B o n d S & P /B a rra V a l u e In d e x 600 500 400 300 200 100 Oct-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Oct-10 The long-term return pattern is more stable than major equity classes Over multiple cycles, covered calls have produced similar levels of growth as public equities Covered calls lag in bull/recovery markets, but provide better downside protection in down markets Less stable than bonds, but higher level of growth 5
-20-18 -16-14 -12-10 -8-6 -4-2 0 2 4 6 8 10 12 14 16 18 20 More Frequency Frequency Considering Covered Calls RATIONALE Distribution of Returns Covered Calls vs. Domestic Equity 120 100 BXM Observations SP5 Observations 120 100 80 80 60 60 40 40 20 20 0 0 Monthly Return - % Covered calls have fewer outliers, tighter return distribution Fewer observations below zero Truncated upside 6
RATIONALE Comparative Statistics Covered Calls Highly Competitive Periods ending 10/31/10 (Ranks based on 5 Year Data) Rank 1 Year 3 Years 5 Years 10 Years 20 Years Comments Annualized Return - % 1 U.S. Bonds 8.0 7.2 6.4 6.4 7.2 2 BXM Covered Call 10.2-3.1 1.9 1.9 9.3 3 S&P 500 Index 16.5-6.5 1.7 0.0 9.3 4 S&P/BARRA Value Index 15.5-9.7 0.2 1.8 9.1 Annualized SD - % 1 U.S. Bonds 3.1 4.1 3.6 3.8 3.8 2 BXM Covered Call 14.1 17.2 13.6 12.5 10.7 3 S&P 500 Index 19.0 21.9 17.7 16.4 15.1 4 S&P/BARRA Value Index 18.4 23.9 19.2 16.6 14.7 Sharpe Ratio 1 U.S. Bonds 2.5 1.5 1.0 1.0 0.9 2 BXM Covered Call 0.7-0.2 0.0 0.0 0.5 3 S&P 500 Index 0.9-0.2 0.0-0.1 0.4 4 S&P/BARRA Value Index 0.9-0.3 0.0 0.0 0.4 Semi SD - % 1 U.S. Bonds 1.6 1.9 1.6 2.0 1.9 2 BXM Covered Call 8.5 13.8 10.8 9.8 7.6 3 S&P 500 Index 11.2 16.9 13.3 12.4 10.1 4 S&P/BARRA Value Index 11.0 18.9 14.9 12.4 10.1 Sortino Ratio 1 U.S. Bonds 95.2 16.1 18.1 13.6 20.5 2 BXM Covered Call 2.2-0.3 0.2 0.3 2.8 3 S&P 500 Index 3.1-0.4 0.2 0.0 1.6 4 S&P/BARRA Value Index 2.9-0.5 0.0 0.2 1.6 Covered calls have kept pace with other equity classes Covered calls exhibit 2/3rds the volatility of equities Risk-adjusted returns typically outperform equities and value stocks Downside risk 2/3rds that of other equity classes Downside risk-adjusted returns significantly greater than other equity classes 7
C orrelation Considering Covered Calls RATIONALE 24 Month Rolling Correlation N o v -9 0 - O c t -1 0 1.0 0.9 0.8 0.7 B XM C o v e re d C a ll S & P 5 0 0 I n d e x B C A g g re g a t e B o n d S & P / B a rra V a lu e I n d e x 0.6 0.5 0.4 0.3 0.2 0.1 0.0-0.1-0.2-0.3-0.4-0.5-0.6 Nov-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Oct-10 Covered calls fluctuate roughly in tandem with domestic equities Implication: potential substitute for equities at lower levels of risk tolerance Key point: despite these features covered calls are not long only equities 8
COVERED CALL STRATEGY BASICS The strategy being considered is passive in nature and straightforward to implement Purchase and hold the S&P 500 (the most liquid and replicable large cap equity index) Sell one-month calls on the S&P 500 that have a strike price just above the S&P 500 s current level If S&P 500 rises, gain determined by call proceeds and market appreciation If S&P 500 rises above call s strike level, no more gains will accrue that month If S&P 500 falls, investor gets to keep call proceeds, providing some downside protection Result: large portion of domestic equity asset class returns are truncated to create a unique return pattern 9
A BRIEF REVIEW OF OPTIONS Option contracts include a pre-established price at which the contract owner could execute the contract to either purchase or sell a specific security (e.g., sell/purchase 100 shares of stock at the pre-set price) This strike price causes option values to fluctuate in a non-continuous fashion Options are also listed on an exchange and standardized Two option types: Puts a contract that provides the right, but not the obligation, to sell a security at a pre-specified price at a pre-specified time in the future Calls a contract that provides the right, but not the obligation, to buy a security at a pre-specified price at a pre-specified time in the future Buyers of options pay a premium and participate in security s gains/losses beyond the strike price; downside loss is limited to loss of the premium Sellers of options receive a premium, but could pay huge amounts if security s gains/losses move significantly beyond strike price; downside losses can be significant and potentially infinite Options sellers are insurance providers 10
A BRIEF REVIEW OF OPTIONS Exercise date Option Premium/Purchase Price Strike Price Option Premium/Purchase Price 11
OPTIONS EXPECTED RETURN PATTERN IN RELATION TO ASSET PRICE Calls Puts + Call value + Put value Asset Long Call (Buy) Long Put (Buy) Asset - + - Asset value + Asset value Short Put (Sell) Short Call - (Sell) Infinite loss potential Infinite loss potential - Source: WAMCO 12
COVERED CALL STRATEGY EXPECTED RETURN PATTERN IN RELATION TO ASSET PRICE Asset + Selling Call Options on that Asset = Covered Call Strategy + Call value Resulting Strategy + Strategy value Asset Asset When Asset Value Rises, Strategy Performs Like Cash - + Asset value - Asset value + When Asset Value Declines, Strategy Performs Better Than Asset Short Call (Sell) - Infinite loss potential - In down markets, a covered call strategy outperforms; a premium is collected but the option contract seller never has to execute the contract In up markets (when the actual stock price moves past the strike price), a covered call strategy underperforms because it will convert to a cash return until the option expires or is exercised; once cash equivalence is achieved, strategy holder will convert cash to asset and start over again 13
COVERED CALLS AND VOLATILITY Covered call strategies provide protection as volatility increases Volatility is a component of the options pricing formula which increases the value of the call options written, increasing the premium received The higher premium cushions performance during volatile market environments For example, during the credit crisis when volatility spiked the BXM outperformed the S&P 500 with significant less volatility Covered calls should also perform well in sideways markets that experience meaningful volatility 14
G row th of $100 Considering Covered Calls COVERED CALLS IN DIFFERENT MARKET ENVIRONMENTS Over long time periods, covered calls tend to produce returns in line with public equities but with significantly less volatility Relative performance can differ meaningfully between a covered call strategy and public equities depending on the overall state of the market Covered calls lag in bull/recovery markets, but provide better downside protection in bear/down markets Covered calls should perform in line with equities in sideways markets and should slightly outperform in volatile sideways markets 160 150 140 Sideways Market Annualized Return, % Annualized StdDev, % BXM Covered Call 7.4 4.4 S&P 500 Index 7.4 7.1 130 120 110 100 90 80 D e c-0 3 Ju n -0 4 D e c-0 4 Ju n -0 5 D e c-0 5 Ju n -0 6 Covered calls keep pace with equities in sideways markets Significantly reduced volatility compared to equities in sideways markets The more volatile the sideways movement the better covered calls will perform relative to equities B X M C o ve re d C a l l S & P 5 0 0 In d e x 15
G row th of $100 G row th of $100 120 110 100 90 80 70 60 50 Considering Covered Calls COVERED CALLS IN DIFFERENT MARKET ENVIRONMENTS Sharply Declining Market 40 A u g -0 7 D e c-0 7 M a r-0 8 Ju n -0 8 S e p -0 8 F e b -0 9 Annualized Return, % Annualized StdDev, % BXM Covered Call -22.0 17.8 S&P 500 Index -33.5 19.8 Covered calls protect principal better during declining markets Covered calls can still lose considerable capital in sharply declining markets Downside protection is limited to the premium on the written call options B X M C o ve re d C a l l S & P 5 0 0 In d e x 170 Sharply Advancing Market 160 150 140 130 120 110 100 F e b -0 9 Ju n -0 9 S e p -0 9 D e c-0 9 M a r-1 0 Annualized Return, % Annualized StdDev, % BXM Covered Call 27.2 13.2 S&P 500 Index 37.9 18.9 Covered calls lag equities in sharply advancing markets The degree of underperformance during advancing markets is directly related to the pace of advance The faster the pace of advance, the greater the relative underperformance B X M C o ve re d C a l l S & P 5 0 0 In d e x 16
SUMMARY Covered call writing is straightforward to implement a virtual passive process Risk-adjusted results are compelling, particularly from a downside risk and volatility perspective Key drawback of covered calls: when the equity market is in a rapid recovery or bull market, covered calls will underperform their straight equity counterpart PCA recommends the Board consider covered calls in the Asset Liability Study 17