Buy-write overlay strategies are well-placed to capitalise on these tumultous conditions by adding a consistent and diversified source of real return to investor portfolios. It’s one of the most basic forms of derivative overlay strategy, where equity is owned, and a corresponding call option is sold over the underlying position. A buy-write strategy effectively replaces ‘expected but uncertain’ capital gains with far more consistent income streams, while still receiving all dividends (and franking credits on the ASX 200).
A buy-write strategy differs from a typical long-only investment strategy in that it converts a large component of return to income. Typically, most investment returns from owning equities are delivered via growth in capital, with a smaller component delivered via income (namely dividends). A buy-write strategy reverses this relationship, with most return coming from income. This conversion to income fundamentally changes the path of investment returns, as income return is more certain, less volatile and protects against losses. However, as return from income is capped, it also causes the strategy to underperform equity markets when they are strong. Over time, total investment returns from systematic buy-write strategies have proven very similar to equities, albeit with a different shape that is reflective of a lower-risk, income-driven return profile.
GENERATING RETURNS DESPITE LOW GROWTH
Research across all major global markets, including Australia, highlights the defensive characteristics of buy-write strategies. As the income is generated at the outset, this needs to be lost before the investor suffers a portfolio loss. Thus, it should come as no surprise that buy-write strategies have historically performed well when markets are weak or low growth, and particularly well when volatility is high and remains elevated. For example, during the GFC, buy-write strategies performed particularly well in terms of preserving capital and hence recovering from drawdowns far quicker than equity indices. Conversely, when markets are consistently strong with low volatility, relative returns suffer (despite delivery of meaningful positive returns in an absolute sense). The strong outperformance in weak and low growth conditions, and underperformance in high growth, reflect the far higher contribution to return from income.
Historically, systematic buy-write strategies have delivered equity rates of return with significantly reduced volatility, improved capital preservation and a higher income component. These characteristics are extremely well suited for investors seeking a lower risk equity return, where preservation of capital and reliability of income is valued more highly than outperforming equity markets when they are strong. As the income generation is not dependent on interest rates or high yielding shares, a buy-write strategy can also significantly diversify the sources of retirement income. This can meaningfully lower risk in a portfolio where often the dominant source of retirement income is generated from a concentrated exposure such as Australian banks. However, caution is advised: just as there are different types of active equity styles, there are different approaches to buy-write strategies, with differing results. Well-managed systematic approaches, which are non-directional in nature, are better placed in our view to deliver the key benefits of a buy-write strategy in a predictable and more reliable return profile.
STATE OF PLAY
Over the past 12 to 24 months, investment returns for the Wheelhouse Global Equity Income Fund have proven to deliver lower risk returns with reduced drawdowns, alongside consistent income generation. One key advantage of systematic buy-write strategies is the high degree of predictability of returns, for a given market return. During 2018 for example, when global sharemarkets were negative, the strategy outperformed by 6% and preserved capital when it was needed most. With the market rebound in 2019, the fund has underperformed by a similar amount, despite delivering an absolute return of over 13%.
Looking ahead, with interest rates seemingly stagnating at record lows and equity markets nearing record highs, the key benefits of a systematic buy-write approach – namely high-income generation and improved capital preservation – would appear well suited for the current market environment. There are a number of buy-write strategies on the market, and investors are encouraged to look for systematic approaches that increase the predictability and consistency of investment returns.
In the US, Morningstar recently reported that overlay strategies have experienced 24% growth in assets under management over the past 12 months, as investors increasingly look for lower risk, higher income yielding investment options. The report suggests that this increase is on track to be one of the biggest advances of the past decade after hitting $US22 billion ($32.5 billion) in August this year. The strategies range in styles and levels of risk. Often, they seek to generate additional income by regularly selling options contracts. Other times, they use options in an attempt to protect against potential stock losses.
This type of investment strategy – like all others – comes with a degree of risk, so adequate risk controls are fundamental to the approach.
Buy-write strategies offer the investor enhanced real returns on equities and are not dependent on style factors such as growth/defensive to reduce risk. The relationships are consistent across jurisdictions, making them suitable for MSCI World as well as Australian-specific exposures, and the index-based buy-write strategies reshape the beta, or the market return. Investors also receive full dividend entitlements, including franking credits on Australian-based exposures, making it particularly appealing in this low rate, low growth environment.
After calculating the global equity exposure – based on the same weightings as the underlying index – the buy-write overlay provided an equity replacement return over this period.
However, when the shape of returns is further analysed, volatility and the frequency of negative periods (on a 12-month basis) significantly improved. Volatility was reduced by 30% versus the equivalent equity exposure, and up to 50% less than the stand-alone indices.
Negative returns were only observed 6% of the time during the 11-year period (versus 19% observed from the equivalent equity exposure), with most occurring during the GFC (when losses were also far shallower for the buy-write overlay). For investors focused on sequencing risk and the importance of avoiding extended periods of negative returns, this can have a meaningful impact on outcomes.
KEY CHARACTERISTICS OF BUY-WRITE STRATEGIES
1. Equity rates of growth – Systematic buy-writes are an equity replacement strategy. While intra-cycle returns deviate from benchmark returns, over longer time horizons returns have been very similar to underlying equity benchmarks (including dividends reinvested).
2. Delivering ‘alpha’ when you need it – Systematic buy-write strategies have consistently generated outperformance when equity markets have failed to deliver on their expected 9%-10% annual return. Specifically, in low-growth environments, buy-writes have nudged annual returns up far closer to ‘expected’ equity returns. Importantly, the relationships are not dependent upon a particular defensive sector or idiosyncratic characteristic. As the following table shows, the results are consistent across markets and time periods, and reflective of the underlying market movement as opposed to intra-market investor preferences.
By delivering equity returns far more consistently, and preserving capital far more effectively, the ‘alpha’ has been delivered precisely when you need it most. Conversely in strong markets, while underperformance should also be expected, highly positive absolute returns were also consistently delivered, as the following chart illustrates.
3. Improved capital security and reduced volatility – The improved defensive characteristics are also reflected in far fewer periods of negative absolute returns on a rolling 12-month basis.
The hypothetical scenario below calculates a simulated Australian investor’s typical equity exposure using the following:
I. 50% ASX 200 Index (total return);
II. 25% MSCI World ex Australia Index (unhedged); and
III. 25% MSCI World ex Australia Index (hedged).
Alastair MacLeod is a portfolio manager at Wheelhouse Partners.
