How to cultivate volatility for income

04-14-2022
How to cultivate volatility for income

ETFs that sell volatility using option strategies

 

The modern-day fiduciary, faced with lower interest rates and higher income needs than their predecessors, should heed the words of Albert Einstein, who once said, “in the middle of difficulty, lies opportunity.”

The Office of the Superintendent of Financial Institutions (OSFI), Office of the Chief Actuary, summarized this challenge from the perspective of a public sector pension plan stating, “the costs of federal public sector pension plans are subject to upward pressure due to a low interest rate environment and improved longevity.”1 During the same period, investment professionals coined the concept of a 60/40 portfolio, anchored in the belief that bonds would produce meaningful income, while also providing a hedge against equities. But that idea has since been disrupted by lower interest rates, which force fiduciaries to lean more heavily on dividend-paying stocks than yield-starved bonds. This overweighting to equities satisfies an income need, though it does raise the question: What’s the impact on risk?

In the current environment, the challenge for fiduciaries is two-fold: First, determine how much equity allocation is required to meet income requirements; and second, to identify and select equity strategies that simultaneously manage risk and maximize income.

Option overlay strategies have emerged in recent years as an innovative solution to this problem. By writing options contracts on a basket of high-quality stocks, investors can collect premiums to enhance their income yet still participate in rising equity markets. Instead of being a peril, volatility can be cultivated as an additional income source.

How options harness volatility

In physics, the law of conservation of energy states that energy can be transformed from one form to another, but can be neither created nor destroyed. Volatility, in this metaphor, is the “energy” of a security, in the sense that whether or not it’s high or low, it is always present. An option contract is a tool that transforms volatility from an observable phenomenon into a source of yield.

While this all sounds great in theory, executing these strategies is more difficult:

  • Writing contracts on segregated holdings is extraordinarily difficult across a large clientele. The exercise is time consuming and not scalable.
  • Commission costs and wide bid-offer spreads make options writing an expensive strategy.
  • Most listed options contracts are for one-, two-, and three-month periods, requiring a large time commitment to monitor positions.

Innovation in covered call ETFs

To improve access and ease-of-use, there emerged exchange-traded funds (ETFs) that helped investors access the benefits of “selling vol” in a straightforward, scalable product. The first iteration was covered call ETFs, which provided three advantages to investors:

1. Enhanced yield. Investors earn the underlying dividends as well as an option premium, thereby increasing the earning power of their equities;

2. Lower risk. Increased income from selling options offsets some of the inherent equity risk in the underlying stocks. Additionally, there is an inverse relationship between markets and volatility – volatility rises when markets fall. In other words, investors who sell options get paid more when markets are riskier;

3. Tax efficiency. Options premia are taxable as capital gains, making them highly effective. This is especially important when harnessing dividend strategies in foreign markets, where dividends are taxed as foreign income. On a post-tax basis, option premium may provide more income than foreign dividends.

The innovation of these ETFs effectively allows the prudent investor to reap all the benefits of “selling vol” without the hassle.

Benjamin Franklin once said, “In this world nothing can be said to be certain, except death and taxes,” so it’s nice to find a strategy that both increases your yield and is tax-efficient. This is primarily of concern to wealth managers, whose clientele of high-net-worth and ultra-high-net-worth families are highly exposed to marginal differences in tax rates.

Understanding the strategy

As the world’s largest options overlay ETF provider,2 we have developed a very coherent methodology which strives to balance yield enhancement with the compound effects of longterm growth. We have three variables to evaluate:

1. How much of the portfolio to cover? Our target is to write contracts on approximately 50% of every holding in the portfolio. All companies will be written to the same degree, though strike prices will be determined on a per-company basis. Writing approximately half the portfolio means the unpledged portion can rise commensurately with the market. Consider the alternative: if we were to write the whole portfolio, we would assume unwanted upside risk, meaning we may be forced to buy back positions at higher prices if the stocks were called.

2. What is the contract term? The options curve is steeper over the first 60 days, so we prefer to write 30- or 60-day contracts, aiming for the agreement to expire worthless as quickly as possible. This ensures we can maximize our premium income, and also means our writing decisions are based on the most upto-date market volatility information.

3. How far out-of-the-money? We always write out of the money (OTM) options with the primary goal of safeguarding the principal investment. As volatility rises in a falling market, we write further OTM to protect from a market rebound, which means we earn higher premiums while protecting the capital in a rising market.

Evolution from the covered call

The next iteration of this strategy was launched in 2020 when our team added put options into the mix. This meant “selling vol” in both directions, earning premiums whether the stock went up or down. And the best part? There’s an understandable skew in options pricing, whereby put premiums will be 2.5 to 3 times higher than those on call options contracts. This is to be expected, because it’s natural to pay more to ensure a position than to speculate on upside growth.

The resulting ETF – BMO Premium Yield ETF (TSX: ZPAY). The product’s construction is simple, but effective:

  • Step 1: Identify 40 to 50 companies that would be attractive at lower prices.
  • Step 2: Write OTM puts to collect a tax-efficient premium, holding T-bills to collateralize the exposure.
  • Step 3: If assigned, take the stocks and write OTM calls on the position, creating a cyclical “buy low, sell high” discipline that maximizes your earning power yet provides capital appreciation as the stocks rise to the strike price.

Armed with this approach, the equity position will rise in a declining market only to fall into the target range when the market rebounds. ZPAY has a comparable yield to the covered call ETFs mentioned above, though its fractional market exposure sets it apart. With approximately 30% invested in equity markets, it provides a uniquely diversified equity play in a balanced portfolio.

Daniel Stanley, CFA, is Director, Institutional & Advisory, Ontario, at BMO ETFs. To learn more, or other ideas to optimize your portfolios, reach out to a BMO ETF Specialist.

This article first appeared in the Winter 2022 issue of Your Guide to ETF Investing, published by Brights Roberts Inc. Reprinted with permission.

Notes and Disclaimer

1. Office of the Superintendent of Financial Institutions (OSFI) Office of the Chief Actuary, “Funding Risks for Federal Public Sector Pension Plans – Presentation to the Board of Directors of PSP Investments,” February 14, 2019.

2. Bloomberg, Covered Call AUM, December 2021.

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