Active Management And Covered Calls: A Productive Investment Pairing

Jun 15 2015 | 5:24am ET

By Ari Sass
Senior Portfolio Manager, M.D. Sass

Many people, including seasoned investors, believe that options are risky financial instruments that use leverage to seek enormous returns on capital. However, when used properly, options can dramatically reduce risk. Writing call options against long stock positions has the effect of selling the uncertainty of capital appreciation for a more certain income stream: the premium the investor receives for an unexercised option is pure, immediate income. If the stock price changes and the option is exercised, that premium offsets the foregone gain in stock value. The practice of buying stocks and selling calls against them is not a new one. In fact, many studies have been conducted to compare the returns from a covered call strategy with those generated by traditional long-only equity investing.

According to a report from Goldman Sachs, selling covered calls on a long S&P 500 portfolio outperformed the S&P 500 outright over the past 16 years. The report further concluded that overwriting produces positive returns more frequently than simply being long the stocks. Another report by Callan states that a passive covered call strategy has generated a return comparable to that of the S&P 500 but with two-thirds of the risk. A study conducted by Ibbotson yielded comparable findings.

The aforementioned studies address the benefits of a plain-vanilla passive covered call strategy. However, there is an inherent weakness in this approach: During periods of low volatility (like today), selling calls on the S&P 500 is the equivalent of selling very cheap insurance. As of this writing, the VIX, which measures implied volatility of the market, is under 12, which is a low number by historical measures. To the investor in a passive covered call strategy, this translates into a low income stream and very little downside protection in the event of a market sell-off. Although the market overall has a low implied volatility, there are many stocks trading with significantly higher implied volatility in their calls. But these stocks aren’t necessarily more volatile over a reasonable time horizon.

Case in point: Ericsson (ticker: ERIC), which recently declined 15 percent due to disappointing earnings. Ericsson has a beta of .96 and is not generally more volatile than the overall market; yet the July at-the-money calls have an implied volatility of 26.5 percent—significantly higher than the overall market. Constructing an actively managed portfolio of out-of-favor stocks and writing covered calls affords an investor the opportunity to sell expensive insurance (calls) against her long stocks and generate high income with better downside protection than in a passive portfolio. If the long stock portfolio consists of high-dividend paying stocks (Ericsson pays an attractive 3.5 percent dividend), then the income stream is even more valuable.

An actively managed portfolio that performs according to the manager’s expectations generates higher income than a passively managed S&P portfolio, but the resulting income still cannot offset the capital loss the investor would experience in a sharp market downturn. One method of adding additional downside protection is to reinvest a portion of the income stream in S&P 500 puts. As mentioned earlier, implied volatility on the market is low and the cost of insurance is relatively cheap. This offers active investors the opportunity to sell expensive insurance (calls on individual stocks) and buy cheap insurance (puts on the market). The risk in this strategy, of course, is picking the wrong stocks while the market goes up. In this scenario, the investor would lose money on both the stocks and the puts. But for a dedicated stock picker, the stock selection risk (with a hedge against market risk) is worth the potential reward of getting paid handsomely for selling most of the upside in the stocks.

Despite the common stereotype that derivatives are riskier than more “traditional” investments, they don’t have to be unless the investor uses them that way. An actively managed, covered call strategy with index put protection affords sophisticated and strategic investors the opportunity to generate attractive and stable income while reducing market exposure and volatility.

Ari Sass is Executive Vice President and Senior Portfolio Manager for the M.D. Sass Equity Income Plus strategy at M.D. Sass, an investment management firm with over $7.5 billion of assets under management. M.D. Sass’s clients include some of the world's largest financial institutions, state and local governments, Fortune 500 corporations, endowment funds, foundations, Taft Hartley funds and high net worth individuals.


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