Income-seeking investors faced significant headwinds in 2022. Dividend stocks, traditionally considered a cornerstone of a yield-focused strategy suffered losses in the recent bear. With interest rates steadily rising last year and into 2023, bond prices bled, leaving even conservative fixed-income investors with no clear direction.
Investors in dividend stocks seeking consistent income must screen for high yields, which may leave them vulnerable to companies with unsustainable payout ratios and poor fundamentals. With bonds, investors must move up in duration or down in credit quality to capture higher yields, which exposes them to greater interest rate or default risk respectively.
With volatility remaining high, one strategy that has the potential to outperform is the options buy-write, AKA a covered call strategy. With this approach, call options are sold against underlying securities, generating immediate income while still ensuring upside participation. However, not all covered call strategies are created equal.
Evolve’s covered call ETFs are designed to provide yield-enhanced exposure to fundamentally sound, diversified equity sectors. The benefits? Comparable returns, higher yields, lower volatility, and reduced drawdowns. The recipe? Strong underlying assets coupled with competent active covered call management.
The underlying asset matters
The overall performance of a covered call strategy is highly dependant on the quality of the underlying asset. Many covered calls strategies default to using well-known indices and commodities, with common examples including the S&P 500, NASDAQ 100, and gold.
The first approach can create heightened market risk. For covered call strategies that track an index, investors are fully exposed to their downside risk. If the market takes a dive, the covered call strategy will follow with a high correlation. If selling covered calls on the S&P 500 index, the investor’s position will crash when the market does.
Conversely, assets like gold might possess a high volatility, which can increase the size of options premiums received from selling calls. The downside is a lack of capital appreciation. Gold, like many commodities does not have a positive expected return. Over time, an investor who sells covered calls on gold might not experience much upside potential.
Evolve’s covered call ETFs are designed with sound fundamentals in mind and a focus on positive long-term expected returns. This involves holding historically resilient market sectors which can outperform under different economic regimes. Examples include:
- ‘Big Six’ Canadian banks and LifeCos, U.S. banks, and European banks, which are subject to strict capital adequacy regulations and can outperform during rising-rate environments.
- Global real estate, materials & mining companies, which have historically offered a strong hedge against inflationary conditions
- Global healthcare companies, which have historically outperformed during recessions, possess lower volatility and sensitivity to market risk.
Source: Evolve ETFs.1As at February 28, 2023. Annualized Distribution yield for BANK, BASE (Hedged), LIFE (Hedged), CALL (Hedged), EBNK (Hedged), BILT, ETSX, ESPX (Hedged). Calculated as the most recent announced dividend amount, annualized and then divided by the current market price. Actual yield changes daily based on market conditions.
Active management makes a difference
Many covered call ETFs on the market take a suboptimal approach to managing the options overlay. While a passive, systematic, and mechanical strategy might be good for a vanilla index fund, it tends to underperform when it comes to covered calls.
The classic example is the covered call ETF that consistently sells at-the-money calls on 100% of its underlying holdings with 30-45 days until expiry (DTE). While this approach is easy to automate and understand, it leaves a lot on the table. Namely, considerations for tax-loss selling, changes in implied volatility, or momentum of the underlying are not considered.
Evolve’s preferred approach is active. Evolve’s fund managers have the expertise and discretion to tactically manage the options overlay, taking advantage of trends, trading around volatility, and exploiting opportunities when they arise.
Covered call ETFs that sell options on 100% of the portfolio’s underlying holdings also severely limits upside potential, which hinders investors from participating fully when markets surge. At Evolve, we cap our covered call overlays on one-third (33%) of the portfolio’s underlying assets.
It’s important to recognize that upside participation plays an important role in an investor’s total returns. Sacrificing too much of this to chase yield can negatively impact overall performance. The covered call strategy is meant to enhance yields, not replace capital gains.
As mentioned earlier, our covered call ETFs provide exposure to equity sectors suitable as long-term holdings on their own. The addition of the covered call overlay can help investors better define their desired risk/return profile and income needs, while still ensuring competitive returns.
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