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hile the global financial crisis that began in 2007 left emerging markets less affected than G-10 countries, the subsequent price behav-ior of BRIC stock markets highlighted once again the need for global investors to control risks through portfo-lio diversification. Typically within a single BRIC coun-try, however, the means to diversify are less available or less well developed than found elsewhere. Within the ETF investment universe, the means for portfolio diversification are even further restricted. For ETFs to continue their growth among emerging markets, then, will require wider coverage of assets and employment of strategies beyond traditional passive indexation.ETF choices among nontraditional, or so-called sec-ond-generation funds, increased notably in 2012. Active management strategies for stocks and bonds now form the basis for rapid growth in developed-market ETFs. This development, which currently lags in BRIC countries, could offer the prospect of increasing the choices for domestic as well as global investors to further diversify their local BRIC holdings and so to increase risk control. BRIC equity markets remain volatile and only mildly trending or even trendless, raising the possibility that covered-call ETFs on recognized indexes could find a foothold in that impend-ing wave of second-generation ETFs. Historical evidence strongly supports the claim that in such an environment, a covered-call strategy delivers superior returns with less than index volatility, thereby making itself an attractive candidate for use in risk control.
Moreover, the continuing strong demand for emerging markets ETFs and investors’ need for enhanced returns in our current low-yield environment suggest that covered-call strategies targeting emerging markets could find a warm welcome in the ETF arena.
In this article, we examine the feasibility of structuring a specialty covered-call ETF to satisfy the rising demand for emerging market ETFs.
Equity Covered-Call ETFs
Covered-call ETFs presently can be found linked to stock markets in the U.S., Canada, Europe and even Korea, a borderline “emerging” market (Figure 1). However, no covered-call ETFs yet exist linked to indexes in the most prominent of the emerging markets: the BRIC countries.
Figure 2 shows which BRIC markets have elements from which to construct such a covered-call ETF denominated in local currency. The requirements are simple: There must be both a convenient ability to acquire equity index exposure and an ability to sell index options. The presence of stocks or ETFs that replicate the index can satisfy the exposure requirement. It may also be possible to obtain synthetic equity exposure using index futures and cash [Slivka & Li, 2010] but this method is sometimes incon-venient, unnecessarily complicated and likely to provide more variable returns. The presence of exchange-traded index calls can satisfy the second requirement.
Any instruments used to construct BRIC covered-call ETFs should have sufficient liquidity to support
continu-ous call writing over a multiyear period. Two countries (Brazil and Russia) have options on index futures, but not options on the index itself, making covered-call construc-tion impractical. China presently has no opconstruc-tions at all.
India, on the other hand, appears to have the necessary requirements for covered-call construction. Index expo-sure can be acquired by direct purchase of stocks replicat-ing the index, while a liquid index options market allows call writing for maturities up to one month and sometimes longer. This makes it possible to construct an ETF using a semi-passive strategy in which one-month covered calls replace written calls as they expire, a topic we next explore.
Covered-Call Returns
One generally recognized benefit of selling calls against long positions in stocks and indexes is that receipt of the time-premium component of the call premium can raise the return on the underlying asset above the return from holding the asset alone. Since time premium for a call is greatest near-the-money, covered-call writers seeking return enhancements often choose strike prices close to the current asset price. A second benefit is that the premium received creates a partial hedge against asset price decline. If the call is written out-of-the-money, the amount of this partial hedge is limited to the pre-mium received. If the call is written in-the-money, the
March / April 2013 53
Equity Covered-Call ETFs/ETNs
BMO Covered-Call Canadian Banks ZWB:CN Canada Horizons Enh Inc Equity HEX:CN Canada Horizons Enh Inc Financials HEF:CN Canada Can-60 Covered Call LXF:CN Canada Can-Energy Covered Call OXF:CN Canada Can-Financials Covered Call FXF:CN Canada Can-Materials Covered Call MXF:CN Canada Lyxor ETF EURO STOXX 50 BuyWrite BWE:BQ Europe MIDAS KOSPI200 Covered Call 137930:KS Korea
PowerShrs S&P 500 BuyWrite PBP:US US iPath S&P 500 BuyWrite ETN BWV:US US Figure 1
Source: Bloomberg
Source: Local exchanges Figure 2
Availability Of Exchange-Traded Instruments In BRIC Countries For Covered-Call Construction
BRIC
full amount of premium offers protection against loss.
Investors using covered calls to protect against meaning-ful losses often choose options deeper in-the-money.
In our study, we selected pairs of NIFTY index call options listed on the National Stock Exchange of India (NSE) having a one-month time-to-expiration (maturity) and strike prices just above and just below the index price at the time the calls were written. A one-month time-to-option maturity offered excellent call liquidity, while the choice of near-the-money strike prices allowed for high time-premium income.
Two standard returns are customarily calculated to eval-uate the attractiveness of covered-call candidates prior to trade execution. They are the stand-still return (RSS) and the if-called (RIC). The RSS is the percentage return-to-option expiry, assuming the underlying index remains unchanged. This return recognizes costs and any dividends payable during the period ending at option expiry. The RIC is the return if the option is in-the-money at maturity and is exercised. The RIC calculation also includes costs and any dividends received by the asset holder between trade date and expiry. A third return, the realized return (RR), is the actual return realized at call expiry, and its calculation must account for any capital gains or losses arising from changes in the underlying index.
Formulas used to calculate these three returns at expiry are as follows:
I = Index level in points on trade date Im = Index level in points at call expiry K = Call strike price
P = Call premium in index points
D = Dividends payable to call expiry in index points G = Costs in index points = Index times a = a I a = 0.65 percent
t = 365 / n
n = number of days to call expiration
For the RIC calculation, the quantity K-I in the numerator of RIC has a convenient interpretation, as it represents the capital appreciation of the asset if the call is initially written out-of-the-money. Otherwise, this quantity will cancel the intrinsic value of the premium if the call is in-the-money when written. Any such cancellation will correctly leave only the time premium to contribute to the return. When an in-the-money call is written, the RIC and RSS are the same. The RIC equation can also be written simply to reflect these facts and isolate the capital appreciation component as follows:
RIC = RSS + MAX[0, K-I] x t / (I + G - D - P ] (4)
Prices for NIFTY calls and projected dividends pay-able each month were availpay-able on Bloomberg and quoted in index points. Typical costs to an institutional covered-call writer appear in Figure 3. For a hypotheti-cal institutional investor, total round-turn covered-hypotheti-call costs amount to an estimated 0.65 percent of traded index value for transactions in which securities are pur-chased and held for one or more days (delivery trans-actions). For retail clients transacting covered calls in smaller size, such costs are easily double this amount.
Covered-Call Performance
Call-writing strategies employed among the covered-call ETFs in Figure 1 range from active to semi-passive. The PowerShares S&P 500 BuyWrite Portfolio ETF, which fol-lows the strategy used to create the CBOE S&P 500 BuyWrite Index (BXM), provides an example of a semi-passively man-aged strategy [CBOE, 2010]. The BXM Index is constructed from the results of systematically writing one-month slightly out-of-the-money calls on the S&P 500 Index where the underlying portfolio is an S&P 500 Index fund. At each call expiration, a replacement one-month call is written.
The performance of this covered-call index has been carefully studied by five authors over the period from 1986 through 2012 (“key studies”). Ibbotson Associates studied the BXM behavior over the period 1988 to 2004 [Ibbotson, 2004], while Callan Associates studied the same index from 1988 to 2006 (Callan, 2006), as did Hewitt EnnisKnupp from 1986 to 2012 [EnnisKnupp, 2012]
and Asset Consulting Group from 1986 to 2011 [Asset Consulting, 2012]. Separately, Kapadia and Szado studied covered-call writing on another index, the Russell 2000
Common Institutional Costs For Covered-Call Writing
Charges On Each Leg Of Delivery Transactions As A % Of Traded Value
Brokerage on Turnover (Traded Value) 0.10%
Service Tax on Brokerage 10.30%
Securities Transaction Tax (STT) For Delivery Trades 0.100%
Exch Transaction Charges for NSE and BSE Trades 0.0035%
Stamp Duty 0.010%
SEBI Charges 0.0001%
Subtotal for Stock 0.2239%
Brokerage on Turnover (Traded Value) 0.035%
Service Tax on Brokerage 10.30%
Securities Transaction Tax (STT) 0.0085%
Exch Transaction Charges for NSE and BSE Trades 0.050%
Stamp Duty 0.002%
SEBI Charges 0.0020%
Subtotal for Options 0.1011%
Round Turn for Stock + Options 0.6500%
Figure 3
Source: Interactive Brokers at interactivebrokers.com Stock Charges
Option Charges
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55 [Kapadia & Szado, 2007] and reached similar conclusions.
All five key studies agreed that:
1. In falling markets, covered-call writing returns out-perform pure index portfolios.
2. In markets trading in a range, covered-call writing also outperforms index portfolios.
3. In rising markets, covered-call-writing returns under-perform index portfolios.
These general findings could have been anticipated by comparing a typical index covered-call gain or loss (P/L) at call expiry, with the gain or loss on the underlying index. A simplified hypothetical P/L profile for this purpose appears in Figure 4, where two breakeven points are easily identified for an at-the-money covered call. The lower breakeven at 95 occurs at a value equal to the strike price of 100 less the ini-tial call premium of 5, while an upper breakeven point at 105 occurs at the value equal to the strike price of 100 plus the initial call premium of 5. These two breakeven points divide the covered-call P/L outcomes into three regions of return:
Region 1: When the index level at call expiry is below the lower breakeven, the investor experiences a realized loss on the covered call but outperforms the index at all outcomes in this region. This result corresponds to the first of the three covered-call findings from the key studies cited above.
Region 2: When the index level at call expiry is between the two breakeven points, the covered call also outperforms the index at all levels, corresponding to the second finding of the key studies.
Region 3: When the index level at call expiry is above the upper breakeven, there is a realized gain on the covered call but this gain is less than that on the index, correspond-ing to the third findcorrespond-ing of the key studies.
While each of these findings could have been anticipated from inspection of Figure 4, many useful numerical results from the key studies required careful detailed analysis.
Important among the additional findings was that covered-call returns were above that of the index for the period 1986 to 2011 and were achieved with a volatility about one-third lower than that of the index alone. This same period included rising, falling and range-bound markets. In rising markets, covered-call writing underperformed the market.
Because returns are capped when calls become in-the-money, correlations between index and strategy returns drop. This latter finding suggests that covered-call writing occupies a position on the capital market line that offers returns in rising markets that are generally below that of the index but above that of cash, much as graphically repre-sented in Figure 5. This position of covered-call writing on the capital market line conveniently suggests that there is also portfolio diversification potential in this strategy.
Covered-Call ETF Benefits And Concerns
Financial journalists often make three negative warning observations about covered-call ETFs. The first warning is that covered-call writing is a strategy that underperforms the market, implying that the strategy should be avoided.
The warning is based on the mistaken assumption that this strategy is designed to outperform the market at all
times. As the key studies clearly demonstrate, covered-call returns should be expected to underperform in rapidly rising markets because capital gains are limited above the call strike price. Conveniently overlooked by journalists is that outperformance of covered-call ETFs can be expected both in range-bound and declining markets.
A second mistake made by journalists is to compare price-only returns from covered-call funds against total market returns. Proper return comparisons between strat-egies can be made only by including costs and dividends received. Such inclusions sometimes reveal a favorable comparison, as was the case from 1986 to 2011, when cov-ered-call writing in the U.S. market outperformed indexes.
A third erroneous claim found in the financial press is that covered calls fail to provide a hedge against declining markets.
Professional covered-call writers know that sold options pro-vide two sources of partial protection against price declines.
For out-of-the-money calls, the premium received provides a partial hedge by lowering the cost basis of the underly-ing asset. For in-the-money calls, the option premium also contains intrinsic value that provides an additional power-ful 1-for-1 offset against asset price declines. Neither in- nor out-of-the-money written calls can provide a complete hedge against a declining market, nor are they designed to do so, as
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Comparison Of Index And Covered-Call Outcomes At Call Expiry
10
8 Maturity P/L For At The Money Covered Call Vs. Index Strike Price At 100; Call Premium 5; No Costs Or Dividends
Lower Breakeven Upper Breakeven
Source: Author’s calculations
Source: Author’s calculations
INDEX MAR-APR INDEX_55.pdf
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Trim Line Bleed Line .125 from Trim
any knowledgeable options investor can confirm.
Benefits and concerns that are appropriate to covered-call ETFs include the following:
Benefits
• Lower fees than actively managed ETFs: The costs of acquiring and managing an index fund are meaningfully lower than for actively managed strategies. Thus, while covered-call ETFs on index funds can be expected to have fees slightly higher than for purely passive index ETFs, the fees will be less than those for actively managed ETFs.
• Diversification: The lower risk of covered-call writing on the capital market line (Figure 5) suggests this strategy has potential diversification benefits for investment portfolios.
• Yield: The systematic capture of call premiums and dividends from covered-call writing both raises the yield and lowers the cost basis of the underlying equity. In Figure 4, it can be seen that returns from covered-call writing dominate those from an index investment right up until the “upper breakeven” point.
• Tax treatment: In countries where dividends receive more favorable treatment than capital gains, the after-tax total return on a covered-call ETF will be further enhanced by receipt of dividends.
• Intraday trading: Pricing and trading are available intraday.
Concerns
• Execution costs: Important to understand is that in India, the costs for delivery transactions (Figure 3) are significantly higher than for intraday trades.
Covered-call writing does not lend itself to intraday high-frequency trading, so execution costs can create a significant drag on returns. The monthly rolling over of
options as they expire also adds to the total costs of this semi-passive strategy.
• Management fees: The analysis of which options to write and when to write them requires extra care by the ETF manager. The attending costs for this effort must be passed along to the investor.
• Underperformance risk: As has been explained, covered-call ETFs can be expected to underperform the index in rapidly rising markets.
Covered-Call ETF Analysis
While the period of our analysis was brief (December 2011 through March 2012), it was sufficient to arrive at useful conclusions regarding the feasibility of ETF
cre-ation, especially knowing that the outcome of any length-ier study of risks and returns would be virtually certain to fit consistently with the findings of the key studies.
The following steps were taken in this covered-call ETF analysis:
Step 1: To identify the best options maturity for cov-ered-call writing, trading volume and open interest were captured for near-the-money NIFTY options from which profiles were constructed. A representative profile appears in Figure 6. Similar open-interest and volume statistics for four consecutive expiry dates suggested that the optimal period for covered-call writing was one to four weeks prior to contract maturity. Writing calls with greater than four weeks to maturity was not sensible due to lower liquidity. Writing calls with less than one week to maturity afforded too little absolute return.
Step 2: In 2011, NIFTY index options were the second-most-actively traded equity options contract in the world [Ackworth, 2012]. Despite this comforting
statis-600,000 500,000 400,000 300,000 200,000 100,000 0
10
0 20 30 40 50 60
Volume And Open Interest NIFTY January 2012 Expiry Call; Strike Price 4900
Volume / Open Interest
Days To Expiration
■ Open Interest ■ Volume Figure 6
Source: National Stock Exchange of India (exchange holiday at 20 days to expiration)
Source: Author’s calculations
Note: Using prices for the NIFTY index and NIFTY calls matched to within one second Figure 7
Number Of Intraday Covered Calls With RSS Exceeding Mibor*
Trade Date ITM Strike OTM Strike
December 29, 2012 2,981 10,948
January 25, 2012 3,129 6,933
February 23, 2012 9,953 12,891
April 26, 2012 3,299 8,493
In India, the costs for delivery transactions are significantly higher than for intraday trades. Covered-call writing does not lend itself to intraday high-frequency trading, so excecution costs can create a significant drag on returns.
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57 The number of covered calls having an RSS exceed
-ing Mibor was recorded on successive expiration trade dates and appears in Figure 7 for contracts both in-the-money (ITM) and out-of-the-in-the-money (OTM).
Step 3: Following a methodology consistent with BXM construction for January through April 2012 expiry con-tracts, nearest in-the-money and the nearest out-of-the-money one-month covered calls were written on each of four consecutive option expiry dates and held to the next ,
2011), two covered calls were separately written for com-parison using January 2012 expiry calls, one being slightly in-the-money and one being slightly out-of-the-money, and these positions were held to their Jan. 26 expiry.
Step 4: In addition to expiry dates on which steps 1-3 were taken, intermediate sample dates were chosen on which to conduct the same analysis. Results confirm the intraday availability of covered-call writing opportunities was substantial on a regular basis using NIFTY options.
As expected, in all three critical regions of the
As expected, in all three critical regions of the