Most investors are concerned with two things when it comes to building a retirement portfolio, risk and return, and it’s often in that order. As retirement approaches, most investors want to minimize their portfolio risk, which often translates to minimizing volatility. In other words, they want to rely on modest consistent returns rather than taking big risks for higher returns.
There are many different ways to minimize volatility in a portfolio, including diversification into multiple asset classes, but buy-write funds have become a popular alternative for stock investors looking to reduce volatility and generate income.
Let’s take a look at whether buy-write funds are actually a good hedge against volatility and why investors may want to consider adding them to their portfolio.
What Are Buy-Write Funds?
Buy-write strategies involve buying a security with options available on it and simultaneously writing, or selling, a call option on that security. The goal is to generate income from the option premium, which offsets any potential losses and generates an extra ‘yield’ on the security. Buy-write strategies on stocks are known as covered calls.
Buy-write funds enable investors to cost-effectively diversify their buy-write exposure across many different securities. In addition, investors don’t have to manage these complex positions on their own and the magnitude of buy-write transactions could create economies of scale when it comes to commissions and other trading costs.
Mutual funds and ETFs involve many fees that investors using buy-write strategies on their own don’t face. For example, most ETFs have an expense ratio — expressed as a percentage — that compensates the portfolio management firm and covers any costs involved with the strategy, such as commissions. Mutual funds may charge a variety of additional fees.
There are more than ten different buy-write exchange-traded funds (ETFs) and even more mutual funds and closed-end funds (CEFs). Each of these funds uses different strategies to generate an optimal return, including a focus on specific sectors (e.g. precious metals or energy) or using put-write strategies that take a related approach to the market.
Buy-Write Funds & Volatility
Many investors use buy-write funds as a way to diversify their portfolio. In particular, they may be interested in reducing their portfolio volatility by enhancing equity positions with downside protection. The five thousand dollar question is whether these strategies actually provide protection and whether that protection is worth the cost to returns.
Let’s take a look at the five largest buy-write funds, by assets under management, to answer these questions.
|Fund Name||Ticker Symbol||Beta Coefficient|
|Global X NASDAQ 100 Covered Call ETF||QYLD||0.66|
|Invesco S&P 500 BuyWrite ETF||PBP||0.57|
|WisdomTree CBOE S&P 500 PutWrite Strategy Fund||PUTW||0.57|
|Global X S&P 500 Covered Call ETF||HSPX||0.81|
|First Trust BuyWrite Income ETF||FTHI||0.73|
*Data as of June 11, 2019.
The average beta coefficient of this group is 0.67, which implies that these funds are about 33% less volatile than the S&P 500 index. However, it’s worth noting that one of these funds uses a put-write strategy and all of the rest use the S&P 500 index as a source of equities for covered calls. A focus on specific sectors could impact volatility in other cases. For example, buy-write strategies on precious metals could be even less volatile than equities.
The risk-adjusted returns of buy-write funds is best assessed by looking at the Sharpe ratio. The S&P 500 index has a Sharpe ratio of 0.88, which is 36% lower than the Sharpe ratio of 0.56 for the Invesco S&P 500 BuyWrite ETF (PBP). This suggests that buy-write funds generate worse returns than the S&P 500 index due to their lower returns. Over a 10-year period the S&P 500 index returned 13.95% compared to 7.07% for PBP.
Finally, buy-write funds tend to generate higher yields than standard equity indexes. The S&P 500 index yields 1.91% compared to the 2.1% yield for the Invesco S&P 500 BuyWrite ETF (PBP). Investors looking to generate above-average income from dividends — such as retirement investors — may want to consider these funds as a way to boost their paychecks. Higher yields is a big benefit to investors needing income but will come with a higher tax liability for investors using taxable accounts.
The takeaway for investors is that buy-write funds have lower volatility and greater yield, but they tend to generate lower risk-adjusted returns than standard equity indexes. Some investors may find that the lower risk and high yield isn’t worth the lower returns.
Alternatives to Buy-Write Funds
There are many different ways to reduce volatility in a portfolio, but the most common is adjusting asset allocations. By shifting the percentage of assets in stocks, bonds, commodities or other asset classes, investors can control their portfolio’s volatility and mitigate other risks. In fact, asset allocation could account for 88% of risk-adjusted return.
For those interested in the buy-write approach — buying a security and writing call options against it, the best alternative to buy-write funds is taking a DIY approach. Finding and executing covered call trades can be difficult and time-consuming without a disciplined approach to screening for the right opportunities and executing on them.
You need to answer tough questions like:
- What stocks are best suited for covered calls?
- What strike price and expirations should be used?
- How much should you allocate to each stock?
- What happens if the stock price rises or falls?
- How many option contracts should you sell?
At Snider Advisors, we screen for high-quality companies that we’re comfortable holding over the long-term. We identify attractive monthly call options to write against this group of stocks to generate a portfolio income as close to one percent per month as possible. Our strategy also uses put writing to achieve our income objectives We call this approach The Snider Investment Method and provide screeners and other tools to find opportunities.
The Bottom Line
Buy-write funds are a great way to reduce portfolio volatility and increase income. While they aren’t the only option to achieve these goals, investors may want to consider them depending on their individual circumstances. Investors looking to execute their own buy-write strategies may want to consider Snider Advisors’ tools to help them find opportunities.