Wade Guenther, CFA, is Portfolio Manager at Horizons ETFs US. In this exclusive article, he details an alternative way to generate yield in one’s portfolio by utilizing an actively managed covered call ETF.
In the fixed income market, yields are at historic lows. The 10-year Treasury yield hasn’t topped more than 4 percent in the last seven years, and investors are forced to go out to a 30-year U.S. Treasury if they wish to find any meaningful yield at all. On top of this, the U.S. Federal Reserve (Fed) monetary policy seems well rooted in the notion of increasing interest rates, which has the potential to erode investor’s capital with many bonds priced at steep premiums above par.
Income has been equally scarce outside of the bond market as well. Increasingly, investors have been ogling equities as a source of income as many companies have escalated their dividend payouts to make their stocks a more attractive investment. Preferred shares, although classified as fixed income, have been similarly attracting investor’s assets thanks to their fixed coupon payments and perpetual term. Outside of these asset classes, Real Estate Investment Trusts (REITs) have also emerged as a popular source of potential income for yield-hungry investors.
However, each of these asset classes come with their own respective headwinds. Preferred shares have been less desirable than their common equity counterparts because preferred shares’ senior lien on company assets has made them safer and less deserving of a risk premium. Common stock, on the other hand, has been trading near-all-time highs, and many industry observers are beginning to forecast the next market correction. Additionally, REITs, like fixed income, have been closely linked to the Fed policy and could be expected to decrease in value with increasing interest rates.
With the pool of attractive opportunities for yield-seeking investors almost completely dried up, wouldn’t it be nice if we could all go into a time machine and find a source of income like we had back in the late 80s when the 10-year U.S. treasury yields were often in excess of 8 percent?
While we may not have a time machine, investors do have access to one strategy that can potentially add yield to a portfolio.
Income from Equities and Covered Call Option Premium
Investing in dividend paying equities and utilizing a covered call strategy has proven effective in increasing portfolio income. A covered call strategy involves holding a long position in an asset, a stock for example, and selling or “writing” a call option on the asset in an attempt to generate additional income from the call premium. The call premium is paid by the buyer of the call option for the right, but not the obligation, to purchase the asset at a specified price (the “strike” price) in the contract on or before the option expiry date. However, this strategy limits the upside potential of the underlying securities.
Generally, option premium has tended to increase when implied, or expected, volatility increases. Many covered call ETFs have paid out most, if not all, of the positive option premiums retained within the expiry period. The addition of option premium in a portfolio has the potential to lessen some of the downside risk that can be experienced when stocks decline.
The Horizons NASDAQ-100® Covered Call ETF (QYLD) is a covered call ETF that owns stocks in the NASDAQ-100® Index in proportion to the index and writes NASDAQ-100® Index options to generate option premium. QYLD paid an average annual distribution yield, which consists of dividends, option premium and possible return of capital, of 9.26% between August 15, 2014, and August 15, 2017. More information about QYLD can be found in the fact sheet here.
Performance data quoted represents past performance. Past performance is not a guarantee of future results; current performance may be higher or lower than performance quoted. Investment returns and principal value will fluctuate and Shares, when redeemed, may be worth more or less than their original cost. See www.US.HorizonsETFs.com/ETF/QYLD to find the most recent month-end performance numbers.
We may not have a time machine to capture the interest rates of the ’80s, but we may not need one. Covered call ETFs and closed-end covered call funds have been an effective way to generate income from dividends and call premium while maintaining the potential for growth from the underlying stocks.
Index Investment Objectives
S&P High Yield Dividend Aristocrats Index: The index is designed to measure the performance of companies within the S&P Composite 1500® that have followed a managed-dividends policy of consistently increasing dividends every year for at least 20 years
S&P U.S. Preferred Stock Index:The index is designed to serve the investment community’s need for an investable benchmark representing the U.S. preferred stock market. Preferred stocks are a class of capital stock that pays dividends at a specified rate and has a preference over common stock in the payment of dividends and the liquidation of assets.
Morgan Stanley Capital International (MSCI) U.S. REIT Index: The index is a free float-adjusted market capitalization index that is comprised of equity REITs. The index is based on MSCI USA Investable Market Index (IMI) its parent index which captures large, mid and small caps securities. With 155 constituents, it represents about 99% of the U.S. REIT universe and securities are classified in the Equity REITs Industry (under the Real Estate sector) according to the Global Industry Classification Standard (GICS®). It however excludes Mortgage REIT and selected Specialized REITs
S&P/Loan Syndications and Trading Association (LSTA) U.S. Leveraged Loan 100 Index: It is designed to reflect the performance of the largest facilities in the leveraged loan market.
Important Disclosures: Authorized for distribution only when preceded or accompanied by a prospectus.
Shares are bought and sold at market price (not NAV), are not individually redeemable, and owners of the Shares may acquire those Shares from the Funds and tender those shares for redemption to the Funds in Creation Unit aggregations only, consisting of 50,000 Shares. Brokerage commissions will reduce returns. The Fund engages in writing covered call Index options on the NASDAQ-100 Index. By selling covered call options, the Fund limits its opportunity to profit from an increase in the price of the underlying Index above the exercise price, but continues to bear the risk of a decline in the index. A liquid market may not exist for options held by the Fund. While the Fund receives premiums for writing the call options, the price it realizes from the exercise of an option could be substantially below the indices current market price. The Fund is considered non-diversified and may be subject to greater risks than a diversified fund. Horizons ETFs Management (US) LLC is the Investment Adviser of the Fund. The Fund is distributed by Foreside Fund Services, LLC, which is not affiliated with Horizons ETFs Management (US) LLC or any of its affiliates. Please visit www.US.HorizonsETFs.com or call 855-496-3837 if you have any questions.
The Horizons NASDAQ-100 Covered Call ETF (NASDAQ:QYLD) was unchanged in premarket trading Thursday. Year-to-date, QYLD has gained 12.13%, versus a 11.48% rise in the benchmark S&P 500 index during the same period.