Saturday, November 14, 2009

Buy-Write: Safe Harbor in Troubled Times?

A covered call strategy may bring long-term in returns with minimal turmoil - By BRETT ARENDS

Is it possible to get decent long-term investment returns without going through all this turmoil?
Some experts say there is -- and recent events, perhaps surprisingly, back them up.
Seven years ago the Chicago Board Options Exchange launched an index to track the performance of a so-called S&P 500 "buy-write" or "covered call" strategy. That's a strategy that involves investing in the Standard & Poor's 500 index and then selling publicly traded investment contracts known as "call options" against the portfolio.
It's not as crazy, or dangerous, than it sounds. Call options are basically bets that shares will rise quickly. The "buy-write" strategy means buying shares and then betting they won't rise quite as far, or quite as fast, as others seem to think.
The rationale: Call options are usually overpriced. Those who sell them tend to make more money than those who buy.
Studies conducted for the CBOE by derivatives expert Robert Whaley (now a professor at Vanderbilt), and investment research firms Ibbotson Associates and Callan Associates appear to bear this out. They used public data on share prices and options to backdate the new index to 1988. Callan, in 2006, concluded that the strategy "has generated superior risk-adjusted returns over the last 18 years… generating a return comparable to that of the S&P 500 at approximately two-thirds of the risk."
In numbers, from 1988 through 2006, Callan said the buy-write strategy had made compound returns of 11.77% a year compared to 11.67% for the S&P, with much less volatility.
Of course, that was conducted before the worst stock market collapse since '29. So how did the CBOE BuyWrite Monthly (BXM) index fare this time?
It has certainly sheltered investors from the worst of the turmoil.
Over the past two years, someone who invested in a regular S&P 500 index fund would be down 43%. At the lows, early last month, they were down 54%.
Over the same period, someone following the BXM would have lost a much more modest 25%. At the worst point they were down 37%.
Over a ten year period, buy-and-hold investors in the total US stock market have lost about 2% of their money. Investors pursuing a BXM strategy would be up about 13%.
But the real appeal of the strategy emerges over twenty years. From April 1989 to the present, the BXM has made total returns of about 400% -- slightly ahead of the broad US equity market. In other words, the buy-write index beat the stock market, with a lot less volatility.
For ordinary investors, a number of investment products pursue a buy-write strategy. Barclays'iPath CBOE S&P 500 BuyWrite Index is an exchange-traded note. IQ Investor Advisors' S&P 500 Covered Call Fund and PowerShares' S&P 500 BuyWrite Portfolio are exchange-traded funds. These seek to track the BXM index before costs. They've only been around for a few years.
There are a host of closed-end funds that pursue buy-write strategies. They come with different benefits and risks. They have been a rocky ride in the past two years because their shares have fallen well below net asset values. But of course those who buy them on sale, and hang on, should make extra profits in due course. (There are no guarantees, however.)
Among straight mutual funds the best-known is Gateway. It has been around since the 1970s. It has a sales load, which will eat into your returns, and it pursues a more complex strategy than simply selling covered calls: It also buys put options to protect the portfolio against a stock market fall. But the fund's record is pretty good -- only down 13% over the past two years, and it's up 29% over ten.
Any buy-write or covered-call fund is going to underperform the stock market during a bull market. But after what you've been through, do you really care?

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