This article appeared in the July 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Tony Rumble, BetaShares
Australian investors have developed a post-GFC love for income: after share prices were slashed and high interest rates rekindled the appeal of deposit products, income investing was spectacularly successful as a way of restoring health to personal investment portfolios.
Over time, as sharemarkets have stabilised and cash deposit rates have fallen, investors have cautiously moved back to shares, often picking defensive stocks with strong dividend income. Rising share prices have in turn led to a search for diversified "equity income" strategies, paving the way for a spate of new products and funds catering to this demand.
One of the most popular of these strategies uses the buy/write approach, where share yields are enhanced by selling call options to generate option "premium."
(Editor's note: To learn more about the features, benefits and risks of options, take the free ASX online options course).
Mechanics of the buy/write strategy
As the name implies, there are two components to this strategy:
- The investor buys (or already owns) shares they are fundamentally comfortable to invest in
- Using these shares as collateral, the investor sells call options in respect of some (or all) of the shares.
Selling a call option gives the buyer the right (but not the obligation) to exercise the call option, which means they will be able to buy the shares from you, normally for a higher price than you paid for them. In return for buying that option from you, the investor pays you a fee, known as the option premium.
Unlike the highly risky and typically unhedged or uncollateralised credit derivatives that triggered the GFC, the buy/write strategy has only two possible outcomes for the originator, the person who buys the shares and writes the call options:
- The share price(s) is stable or falls, in which case the call option is not exercised - the originator has taken in the option premium and remains the holder of the shares (the share price is below the option "exercise price" at maturity of the call option).
- The share price(s) rises above the call option exercise price, in which case, in addition to having taken in the option premium, the originator will be called upon to sell the shares at a profit compared to their cost price.
In scenario 2, the amount of profit is set by the level at which the exercise price of the call option is set. When a call option exercise price is set above the current share price, this is known as an "out of the money" strategy, and the amount of option premium received is directly linked to the degree to which the exercise price is "out of the money."
In both cases, the option premium provides income which, when added to the dividend on the underlying share, boosts the overall income from that share.
Does it work?
The buy/write strategy can be considered as a way of reducing the risk of holding shares directly.
- Each time you earn option premium, this is a way of subsidising or reducing the effective entry price into the stock.
- If you place the option premium into a cash deposit product, the overall sharemarket exposure of your portfolio is reduced.
That all sounds good in theory, but what is the real-world experience for buy/write strategies?
ASX commissioned an academic study analysing the actual returns of a variety of buy/write strategies during the period 2005 to 2011. It measured the actual returns generated from the buy/write approach.
The research (summarised in the chart below) used actual data for 30 blue-chip stocks over the periods before and after the GFC and shows that (depending on the specific buy/write strategy used, as shown in the different strategies below on the cart) it was possible to add between 20 per cent and 60 per cent to basic share returns between April 2005 and December 2011.
Line chart showing impact of buy/write strategy for 30 blue-chip stocks
Source: ASX Limited, 'An Encyclopedia of Buy-Write Returns (April 2005 to December 2011)'
The Basic approach assessed in the study used a simple strategy of selling ASX exchange-traded options (ETOs) with a term or maturity date of one month, and with an exercise price 5 per cent (or as close as possible) above the share price at the time the call option was sold. The study also highlighted that the buy/write strategy tends to outperform the Basic share returns when share prices are flat to negative, or trending gently upwards, while tending to underperform when share prices rise strongly.
Implementing the buy/write strategy in practice
ASX has a range of educational tools and option pricing calculators available online to assist DIY investors access the buy/write strategy. The relative complexity often leads to the search for a broker to assist with selection of stocks and/or options, and ongoing position management.
Some additional complexity arises for DIY investors, who must also consider:
Setting exercise prices to balance the premium received against the possibility of the option being exercised.
Measuring option "implied volatility" (and fair value) even if the ASX online calculator is used.
Rolling over positions as the option expiry date approaches.
Choosing whether to prevent exercise of the option by buying back the position (or letting the option be exercised).
Using an investment product to access the buy/write strategy
It is little wonder that the market abounds in financial products that use the buy/write strategy to generate an equity income-style return. These funds offer the potential for diversification for investors who would otherwise simply hold individual defensive-style stocks, as well as aiding diversification through accessing the buy/write investing style.
Table 1 below shows a range of investment funds that seek to produce an equity income-style return; those that use the buy/write approach are marked with an *.
The table shows a variety of equity income-style products, including the three main types of product that use a buy/write strategy:
- Blended open-ended funds
These may invest in high-yield stocks, hybrids, as well as using the buy/write strategy. Each strategy is implemented based on the fund manager's market view, and accordingly the type of exposure within the fund may change over time.
- Listed Investment Companies (LICs)
Typically these also invest in a range of assets and may implement the buy/write strategy at various times during the year, based on the LIC manager's market view. Unlike open-ended funds, LICs can trade at significant premium or discount to their net asset value (NAV), depending on the market demand for the LIC.
In the case of a LIC such as Djerriwarrh, a very popular investment because of its consistently strong returns, at the end of May 2014 the DJW share price was trading at a 24 per cent premium to underlying NTA (source: ASX Funds Monthly Update).
Buying LICs at a premium to NTA dilutes real returns and the effective level of exposure to the underlying strategy. For example, $1 of new money invested into DJW when it trades at a 24 per cent premium to NTA would equate to $0.76 of exposure to physical assets (of which not all may be deployed into the buy/write strategy).
Single-purpose funds, such as BetaShares Equity Yield Maximiser Fun, which holds the S&P/ASX 20 stocks as the underlying assets (ASX code: YMAX), are rules based and permanently implement a buy/write strategy.
Table 1: Selected Equity Income Products
|Indirect cost ratio (ICR) %||12 month yield
to May 2014
|BetaShares Aus Top 20 Eqty Yld Maximiser||13.22||0.79||9.22|
|Zurich Investments Equity Income||10.43||1.87||8.09|
|CFS Wholesale Equity Income||11.20||1.27||7.81|
|Legg Mason Australian Equity Inc A||6.37||0.98||6.58|
|Merlon Australian Share Income Fund||7.77||2.00||5.11|
|Russell High Div Australian Shares ETF||11.54||0.34||4.93|
|Vanguard Australian Shares High Yld ETF||13.86||0.25||4.41|
|Vanguard Australian Shares High Yld||13.65||0.40||4.25|
|iShares S&P/ASX Dividend Opportunities||6.28||0.30||4.22|
|SPDR MSCI Australia Sel High Div Yld Fd||8.64||0.35||4.08|
|Perennial Value Shares for Income Trust||12.54||0.92||3.95|
|Tyndall Australian Share Income||12.75||0.95||3.39|
Source: Morningstar Inc
The periods measured in the table include those of relatively strong sharemarket growth and others when markets were relatively flat. The returns from funds such as BetaShares YMAX Fund (a sole-purpose buy/write fund) are consistent with the ASX research shown above in the chart.
It can be seen from the return profile of the YMAX fund that the buy/write approach it implements performs in line with expectations - that is, with the potential to underperform in strongly rising markets, but outperform in moderately rising, sideways or falling markets.
This may be of interest to investors who believe market returns may be slightly muted, or investors whose focus lies not so much in high capital growth, but rather high yield with lower volatility from blue-chip shares while still getting some capital growth potential. In the period shown in Table 1, the volatility of YMAX returns is less than 20 per cent compared to that of the underlying shares.
About the author
Tony Rumble, PhD, is a Sydney-based asset consultant who provides educational services to the financial services industry, including ASX and BetaShares Capital Limited. The author does not receive any financial benefit from any of the investment products discussed in this article.
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