U.S. and global equity markets have enjoyed a months-long rally from their March lows, fueled by improving macroeconomic conditions, surprisingly healthy corporate earnings, and renewed consumer confidence. Following this tremendous rally, we are beginning to see indications that the market rally is running out of steam, as many sophisticated investors are beginning to pull out of the market amidst fears that stocks are overbought.
Yet there remain many reasons to be optimistic. Unemployment is showing signs of peaking. Consumer confidence is staging a comeback. And most global equity benchmarks are still well below their all-time highs, giving optimists reason to hope that there is more upside to come.
Given these conflicting indications, it’s very possible that equity markets will take a pause from their climb higher, but won’t begin to retreat into a “double dip” recession. If the markets do indeed move sideways for a while, ETFs that implement a “covered call” strategy, also known as buy-write ETFs, could be an interesting investment play.
Buy-write ETFs are one of several types of funds that offer the opportunity for investors to attempt to generate alpha, or superior risk-adjusted returns, while still reaping the benefits of the exchange-traded structure (see our Free Guide to ETFs for High Net Worth Investors for a more thorough overview).
A covered call strategy involves buying the stocks that comprise an underlying benchmark while simultaneously selling call options on the index. The options sold generally have an exercise price at or above the current level of the index. Since this strategy involves writing options, investors receive the premiums on these options as they are written. If the index falls or remains near its current level, the investor keeps these proceeds as the options expire worthless. As such, a covered call strategy provides some downside protection in a bear market, and may generate premiums in a non-trending market that will improve overall return.
Of course, the covered call strategy isn’t without its drawbacks. If the benchmark index posts significant gains, investors in these ETFs may miss out, since the obligation to the purchasers of the options sold by the fund will increase with the benchmark. As such, investors implementing a covered call strategy in a bull market may lose out if markets continue their march higher.
Buy-Write ETF Options
While covered call strategies were once reserved for more sophisticated investors, the development of the ETF market and innovation in product offerings has made this strategy available to smaller retail investors. There are several ETF options for those looking to gain exposure to a buy/write investment style.
- PowerShares S&P 500 BuyWrite Portfolio (PBP): This ETF tracks the CBOE S&P 500 BuyWrite Index, which implements a covered call strategy on the S&P 500. PBP has an expense ratio of 0.75%, and has gained about 12.3% in 2009.
- iPath CBOR S&P 500 BuyWrite Index ETN (BWV): BWV tracks a similar index to PBP, but is structured as an exchange-traded note (ETN), meaning it is essentially a senior unsecured debt instrument issued by a financial institution. BWV has an expense ratio of 0.75% and is up by about 20% so far in 2009.
- PowerShares Nasdaq 100 BuyWrite Portfolio (PQBW): The index underlying this ETF is the Nasdaq 100, a basket of technology stocks traded in the U.S. This ETF has performed slightly better than the funds based on the S&P 500, rising nearly 31% so far in 2009. PQBW also has an expense ratio of 0.75%.
Disclosure: No positions at time of writing.