Combining income and growth to protect long-term returns
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|ETF Investment Strategist|
- Market corrections are likely to become more frequent in the late-cycle phase
- Higher income 'buffers' reduce volatility drags on long-term returns
- Combine income and investment growth efficiently through a covered call overlay
Exiting the expansionary phase
The October global market rout looked like a market correction, similar to the one in February, rather than a shift in the economic outlook. Equity volatility spiked briefly above 27% on the 11th of October before stabilising around 20% more recently. The S&P 500 index dropped 6.9% from its record highs on 20 September to 11 October 2018, due to the escalation of the trade war between the US and China, and has so far failed to resume its upward trend.
The global economic outlook remained solid, reducing the risk of an imminent bear market. After examining current market indicators compared to their levels prior to the past two major financial crises, we are cautiously optimistic about the global stock market. In the table below, we summarise the main indicators for the MSCI World Index.
Source: BMO Global Asset Management, Bloomberg as at 22-Oct-2018.
Current equity valuations are stretched and in line with levels seen prior to the 2007 crisis but corporate profitability is high overall. Globally, companies exhibit a lower equity multiplier than before the past two crises, as well as lower financial leverage. Economic activity is strong, evidenced by high US manufacturing PMIs, albeit losing momentum.
Market indicators also point to relatively sound conditions but raise some warning signals. The US Treasury yield curve is almost flat, which has been a downturn signal in the past, and the US yield gap, defined as the difference between the average dividend yield of the S&P 500 Index and the 2-year US Treasury yield, is negative and declining.
As we move towards a mature global economy with increased economic and geopolitical uncertainties, the low volatility regime is likely to end. The upcoming US mid-term elections, the ongoing Brexit negotiations, the Italian fiscal challenges, the increase in US interest rates and the threats of global trade wars, are all likely to continue to act as disruptive factors for global markets. Overall, market volatility is expected to remain elevated as the economy moves away from the expansionary stage to enter a late-cycle phase.
Volatility can erode long-term returns
The February and October sell-offs have led many investors to look to reduce volatility and downside risk in their portfolios. One way of achieving this is through income-producing investments. The stream of income acts as a downside buffer and enhances yields, lowering the volatility of returns. This is a distinct advantage in uncertain times.
It has long been acknowledged that volatility has the potential to erode investment returns over the longer term. This phenomenon, so-called “volatility drag”, highlights the importance of risk management. If the price of an investment (US$100) drops 10% on one month, and rebound 10% the following month, the investment value is US$99 at the end of the second month. The average return over the two months is 0%, but the total return is -1%. Thus, if an investment loses 10%, it would need 11% to get to break even (i.e. total return equals 0%). In this example, the volatility drag is 1%.
Reducing volatility via a cover call overlay strategy
One way to reduce volatility is through a covered call overlay. This involves selling call options against an equity index in exchange for an immediate additional cash flow (the call option premium) on top of the stock dividend, increasing the overall yield of the portfolio.
In the charts below, we investigate the relative drag from volatility on the long-term returns of the S&P 500 index and the CBOE S&P 500 2% OTM BuyWrite Index (BXY), which tracks the performance of a hypothetical covered call strategy on the S&P 500 Index. While the S&P 500 index posted higher average annual returns than the BXY index over the last three decades, the higher volatility of the S&P 500 index resulted in the same compound return as the BXY index. The difference between the geometric and arithmetic averages over the long term is a proxy to quantify the volatility drag on investment returns.
 Tom Messmore titled “Variance Drain – Is your return leaking down the variance drain?” (1995)
The charts below show that the covered call overlay strategy has provided equity market exposure with persistently lower volatility over the past three decades. Furthermore, this strategy is most likely to outperform in bearish, non-directional and slightly rising markets which are possible market conditions in a late-cycle phase. Conversely, the strategy underperforms in a strong market rally.
October implied volatility overview
Below, we compare the implied volatilities of S&P 500 call options at different strike prices before and after the October sell-off. The increase in overall implied volatility following the market correction (upward shift of the implied volatility curve), suggests that market participants expect volatility on the S&P 500 index to remain elevated in the month ahead. Besides, the volatility curve has steepened (i.e. the implied volatility for in-the-money call options, with low strike prices relative to the underlying, have risen faster than out-of-the-money call options, with high strike price relative to the underlying) compared to the beginning of October. The relatively higher implied volatility for in-the-money call options - typically used for speculative investment - reflects the increased demand for out-of-the-money put options - typically used for hedging purposes - implying that market sentiment is becoming more negative on the upside potential for the S&P 500 index. Overall, option pricing suggests that the US market has possibly already peaked.
*Moneyness is the relative position of the current price of the S&P500 index with respect to the strike price of a call option.
The rise of implied volatility increases the premium received from selling call options and therefore is likely to be beneficial to a covered call strategy. The BXY index assumes a full coverage of the equity portfolio by the covered call overlay, which could possibly limit the upside participation when markets rise.
Best of both worlds
To enhance the potential upside participation, the BMO Enhanced Income strategy sells index call options against approximately half of the equity portfolio, which replicates one of the regional stock index (S&P 500, FTSE 100 and Euro Stoxx 50). By selling call options, we forfeit some potential upside participation, but only on half of the equity portfolio, thus combining income and investment growth. If the volatility level settles at its long-term average (15-20%), the annualised option yield will gradually increase from a target of 2% per annum in the previous low volatility environment, to around 3% per annum in the UK, US and Europe.