Do you want to keep your dividends but reduce the risks? -Alastair MacLeod


As market returns trend lower, many investors are becoming aware of the underlying risk in their portfolios. Over the past few years, with interest rates steadily heading towards zero, investors who rely on income have been strength further down the risk curve in order to generate a sufficient return.

As a result, many investors’ cash weightings are down and equity weightings are up…meaning the overall portfolio risk is considerably higher. This is not ideal as we are potentially heading into an economic downturn, but there have been few other solutions for investors starving for income.

Is there another way to get full dividend yields, including full capital returns, but with less risk?

In this thread, we will present a systematic approach that over the past 18 years has captured the full dividend yield of the Australian market and the full return of equities, but has achieved this with around half the beta (or risk) of the market. Later we will also introduce our Australian fund which uses this source of superior risk-adjusted returns to target alpha or outperformance.

Equity return for half the risk? Whichever way you cut it, that means superior risk-adjusted returns

Introducing the BuyWrite S&P/ASX 200 (XBW) Index

The BuyWrite S&P/ASX 200 Index (XBW) was created by the ASX in 2004 to track the performance of a systematic BuyWrite strategy, perhaps the best known of all options trading strategies. Over the past 18 years, the XBW has provided similar equity returns to the S&P/ASX200, including full dividend capture, but for a beta of about half of the broader market.

Source: Wheelhouse, Bloomberg. Beta calculated daily.

We emphasize that “beta” is a relative measure of risk (relative to the market) and that there are other measures of risk that are also meaningful, such as volatility and downside. On these measures as well, the XBW index has lower risk relative to owning the market. For example, year-to-date (5/13/22), the XBW index is positive by +0.7%, against the S&P/ASX 200 Accum index which is down -5.2% .

How it works?

The XBW owns all the shares of the S&P/ASX200 and enjoys all the benefits of stock ownership, including receiving fully franked dividends (franchised values ​​are not included in the table above). In addition, the strategy writes a call option on the index at the 3 month parity on the entire stock position. The option position is held until it expires each quarter, before it is reset and a new 3-month at-the-money option is sold.

What is a call option? A call option gives the buyer the right, but not the obligation, to buy stock at some point in the future. In a BuyWrite strategy, call options are soldwhich generates income and reduces risk, but foregoes the capital increase in the event of a market recovery.

The strategy’s returns in a positive market consist solely of the option premium that is received each time the quarterly option is sold along with the dividend income. In bear markets, the covered call option also provides an element of risk reduction, as well as receiving dividend income. Throughout the cycle, these characteristics combine to halve the risk of owning the ASX200 outright from a beta perspective.

At Wheelhouse, we have long been intrigued by the risk-reducing properties of systematic index-based overlay strategies, to the point that they form the basis of all of our investment strategies.

What does the XBW strategy leverage?

When call options are written, the premium received is influenced by market expectations regarding future price movements in the ASX200. This is called implied volatility. Historically, implied volatility has always been higher than actual or realized volatility, which is the actual price movement in the ASX200 over the period.

This difference between implied volatility and realized volatility is known as the volatility risk premium and is an integral part of the returns of systematic option writing strategies.

What can go wrong?

The XBW holds a full portfolio of stocks and takes some stock risk. If the market drops 10% or 20% overnight, the index will carry most (but not all) of that drop. The difference is due to the receipt of the option premium from calls sold, which helps to reduce losses when drawing.

From a relative return perspective, BuyWrite strategies are likely to underperform an equivalent portfolio of stocks in strong rising markets, but outperform in lower growth or declining markets.

Higher returns for risk

By producing equity returns throughout the cycle while assuming only about half the risk, it’s fair to say that the BuyWrite Index has generated very strong risk-adjusted returns.

To put it another way, the return per unit of risk (beta) is almost double of owning the ASX200 index itself. This strong risk-adjusted return is reflected in high Sharpe ratios and is broadly consistent with the characteristics evident in other systematic overlay strategies globally.

For many investors with a low tolerance for risk, but who still want to receive full dividend yields on top of stock returns, this return profile can be the ideal building block for building a low-risk stock portfolio. . We caution all investors against using derivatives without the proper risk management tools and trading experience. Our Global fund applies this low-risk approach to a Global equity portfolio, targeting a return of 7-8% for around half the market beta.

One step closer – Converting strong risk-adjusted returns into alpha

However, for investors willing to take full market risk, we were intrigued to see what impact underlying portfolio leverage had on returns. With the XBW strategy generating high risk-adjusted returns, we thought adding some gearing would provide market-beating alpha or returns.

Hence the design of the Wheelhouse Australian Enhanced Income Fund – where we use the same underlying principle of the XBW Index, however, we internally tailor the underlying equity exposure so that the risk matches that of the S&P/ASX200 index (i.e. a beta of 1) .

With risk adequacy, the Fund targets 2-3% outperformance without the need for stock picking or market timing. In addition, investors benefit from up to double the fully franked yield of the market.

Can the Fund be used to reduce risk?

For income investors looking to reduce risk, the Aussie Fund aims for an all-outright return of twice the market. This can allow investors to reduce their overall equity exposure, while achieving a similar income goal. With cash yields still low (but likely rising), reducing overall equity exposure will free up capital to reweight back into the safest of all asset classes, cash.

Separately, for investors more focused on relative outperformance, the strategy targets alpha from a completely different source than most other strategies that rely on stock picking. Since the primary risk reduction mechanism in the strategy (the overlay) also generates income, this additional source of return forms the basis for benchmark outperformance.

Looking for a single source of revenue-driven alpha?

For investors looking for a completely unique source of income-driven alpha for their portfolios, as well as a target return of up to 2x the market, the Wheelhouse Australian Enhanced Income Fund may be worth a look.

Please click here to learn more

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