Higher Yield and Lower Volatility
September 4, 2012
Advisors have told me options are too much trouble to incorporate into client portfolios. Even a covered-call strategy, which is as simple and safe as options strategies get, requires resources to implement and manage. But it’s worth the effort. The incremental yield from a conservative covered-call strategy provides income that exceeds what 10-year Treasury bonds can offer.
Evolution of the UIP
My original 2010 version of the UIP combined an allocation to a closed-end (CEF) high-yield bond fund (COY) with equities in three sectors: utilities, telecoms, and pharmaceuticals.
Original UIP from August 2010
At the time that I proposed it, this portfolio had a 6.1% yield. The market has rallied dramatically since then. As the price of a stock or bond increases, its yield decreases. Those increases are to the advantage of current investors but lower the expected yield. COY had a yield of 10.5% when that first version of the UIP was published. Today, COY yields 7.8%. The yield of this portfolio is 4.7%, considerably lower than the 6.1% when the portfolio was first constructed, but still very attractive when compared to a range of other alternatives.
The projected risk (volatility) of this portfolio was 21%, equal to the implied volatility of a long-term bond index (TLT) at the time. Over the next 12 months, the annualized volatility of the portfolio was 8%, half of what was originally projected. The risk constraints for the projected volatility are intended to maintain portfolio volatility at an acceptable level. The lower-than-expected volatility benefited investors.
By selling covered call options against the nine equities in this portfolio, the UIP generated an additional 3.6% in annual return, bringing the total annualized income up to 9.7%. This additional income available owed primarily to the high level of volatility that persisted in the capital markets at the time. Higher levels of volatility increase the values of options.
The income for the 12-month period was 9.7% and the portfolio gained an additional 5.1% in return from price appreciation, for a total return of 14.8%.
UIP as of August 2011
In August 2011, I reviewed the performance of the UIP and modified the asset allocation by including MLPs (KMP and EPD) and, less significantly, by replacing the high-yield CEF (COY) with a high-yield ETF (HYG) with a lower expense ratio.
Updated UIP from August 2011
The other change was that I varied the weights of the portfolio components to maximize yield while minimizing risk. This portfolio also achieved a yield of 6.1% over the ensuing 12 months, equal to the yield at the time of its construction, in part thanks to the contributions from the MLPs and some riskier (but higher yield) stocks, such as FTR and WIN.
I selected call options to sell against each of these holdings, choosing the strike prices to retain some potential price appreciation; the income from these increased the portfolio’s yield by 2.6%. The total expected income from the portfolio, then, was 8.7% for the total portfolio (6.1% in direct income plus 2.6% in option premiums) – slightly less than the previous year, but still robust.
In the year that has passed since I created the 2011 UIP, the market enjoyed a substantial rally, benefiting the portfolio. From the end of July 2011 (that article came out on August 2) through the end of July 2012, the S&P 500 has provided a total return of 8.8%. The total return of the 2011 UIP over that period was 18.0%, more than doubling the S&P 500.
If call options were sold against the holdings, the portfolio’s total return over this period would have been 10.5%, consisting of 6.6% in income and 4.9% in price appreciation and call option premiums. The gains from the holdings are capped by the options, but the option premium increases the total income. The projected income for this portfolio at the time of construction was 8.7%. The realized total return, including the sales of the covered calls, exceeded that because the market rose.
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