As investors become more educated and more comfortable with options strategies, understanding the nuances of individual strategies within the category may help advisors select the best fund for their portfolio. I recently sat down with T. Rowe Price’s Tim Gilligan to talk about the firm’s actively managed T. Rowe Price Capital Appreciation Premium Income ETF (TCAL) and how it differs from other strategies in the category.
A Top-Down Look at TCAL's Bottom-Up Strategy
Karrie Gordon, staff writer, VettaFi: Tim, thank you so much for your time today. Let’s kick things off with a talk about the core thesis of TCAL and what sets it apart from the pack.
Tim Gilligan, CFA, senior ETF sales specialist, global distribution at T. Rowe Price: If you look at a lot of the strategies out there today, many writing call options are actually using index-linked notes. Those come with counterparty risk and are a risk I don’t think gets talked about enough.
Looking at a big source of how options are priced, volatility makes up a big component of that. Writing options on an individual stock, in theory, should have greater volatility than a diversified basket of securities. If people want income from a covered call option, you’re going to get higher income from writing it on an individual stock.
We also know that creating a portfolio of 60 to 70 names can be operationally challenging. How do you scale a covered call strategy on that many names as opposed to just using options on an underlying index? But David Giroux and his team have been using covered call options in their Capital Appreciation franchise for a very long time. We have the experience, the expertise, and the operational know-how to scale it.
We also think we’ve found a sort of anomaly in the markets that we’re taking advantage of. If you look at low-beta names in particular, the difference between what the market expects future volatility to be versus what is realized is actually greater. And so that allows us to harvest or capture that extra premium. So, we feel we’re benefiting from writing options on individual stocks and also taking advantage of this low-beta anomaly. The portfolio itself has a beta of roughly 0.5, constructed using bottom-up, fundamental analysis. We’re fairly heavily engaged with management teams but we’re also using a large degree of quantitative research within the strategy.
Harnessing Giroux's Capital Appreciation Strategy
Gordon: You mentioned David Giroux, the portfolio manager for the Capital Appreciation Strategy, and the co-PM for TCAL. Can you talk a bit about his core strategy and how TCAL differs from that?
Gilligan: Sure. Giroux and his team — their core franchise is the Capital Appreciation Fund — it’s where he gets his acclaim and Morningstar ratings from. If you think about how that strategy is run, it’s roughly a 60/40 portfolio with 60% equities and the balance of that being bonds. Within that sleeve they do write covered call options. A product like TCAL or TCAF, T. Rowe Price Capital Appreciation Equity ETF, are just extensions of what he and his team are already doing.
It’s basically taking what they are already doing and repackaging it and delivering it to the marketplace to meet market demand. There’s certainly, for TCAF, a strong demand just for the equity sleeve, because some advisors want control of that balance between stocks and bonds.
And look at the growth of the options category and demand from the advisor marketplace. There was certainly interest from the advisor community for us to take what he’s doing with the covered calls in the Capital Appreciation franchise and bring it to market in a different wrapper. We tweaked it, obviously, because we thought we could bring it to market in a more efficient way in TCAL.
Under the Hood of the Options Strategy
Gordon: We’ve talked about the stocks themselves in the portfolio, and some of their characteristics. Let’s turn to the options that the fund is using. Beyond writing calls on individual stocks, what is different about TCAL’s options?
Gilligan: I think what’s interesting here is the way the options are. We introduce flexibility as to how we write our options. If you look at a portfolio like this, for 90% of the names, we’re writing 4%-5% out-of-the-money on a monthly basis. But for the 10% where we have high conviction, we’re going to write those a little further out-of-the-money. We want to let those securities run a little bit to get some total return, and we’ll accept a little bit less premium to do so.
We are getting positive feedback from advisors that like the fact that our options are just that — options. They’re not equity-linked notes, they don’t come with counterparty risk. They’re just a thoughtful approach to writing options at the individual stock level, potentially getting a greater premium and having less downside.
TCAL Performance Expectations
Gordon: Let’s talk a bit about performance expectations. Options strategies generally offer diversified performance compared to benchmarks in various market environments. What should investors in TCAL expect in a challenging market like this year’s?
Gilligan: This is where that 0.5 beta shines through, offering some downside protection when markets drop. I also think the income from the call options further provides additional cushion. You might see us lag in high-octane markets. When you’ve got a portfolio of low-beta names in a high-momentum market, you’re not going to see us going one-for-one with that market.
People are buying this product for the income, and we’re going after a very healthy income from the option itself. We’re also going to get the dividends from the underlying securities, and we hope to get a little bit of capital appreciation from the stocks themselves. It’s a conservative equity portfolio, by design.
TCAL Use Cases & What's Top of Mind for Advisors
Gordon: How do you see advisors using TCAL in their portfolios? And what are some of the common questions or concerns you get about the fund from advisors?
Gilligan: It really depends on the investor. People use it in different ways, but 5% allocation to a portfolio like this is generally what we see. And usually, we see one product filling that category in an overall portfolio. As far as questions, the biggest one is people wanting to know how we write our options. Another big one is the tax implications of the fund. People want to know if this is a tax-efficient or inefficient strategy.
Anytime you have an income product, it’s going to be inherently not as tax efficient. That’s because it’s going to be pushing a lot of income. That being said, we do think that our product will be more tax efficient than the category. If you look at a lot of other options strategies, their distributions from notes are taxed as ordinary income, we expect individual options premiums to be categorized as short-term gains. That gives us flexibility to potentially offset some gains with losses from the portfolio. But it’s a potential benefit, not the goal of the strategy.
A final part of this is low fees. One of the things that the ETF wrapper allows us to do is be very flexible on fees. TCAL, at 34 basis points, is cheaper than a lot of the largest options income ETFs on the market right now.
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