Covered Call Strategy Suited to Super
by Leeanne Bland Another study has confirmed earlier research by SIRCA that writing covered calls (the so-called buy-write strategy) can increase returns and reduce risk.
The latest study, by Nadima El-Hassan, Tony Hall, and Jan-Paul Kobarg of The University of Technology Sydney (UTS), analysed the performance over the period July 1997 to June 2004 of a portfolio invested 40% in Australian equities, 25% in international equities, 20% in fixed income, 10% in property, and 5% in cash, where a covered call strategy was implemented by selling slightly out-of-the-money stock call options on the Australian equity component of the portfolio as represented by the stocks in the S&P/ASX 20 Index.
Options were selected to be 5-15% out-of-the-money with maturities of three months or nearest available expiry after three months. The portfolio was rebalanced quarterly, with the rebalance dates chosen to coincide with quarterly option expiry dates.
The authors found that the covered call strategy had the effect of increasing the average return of the portfolio by 0.16% per annum and reducing standard deviation by 0.71% per annum, thereby improving the risk-adjusted returns of the portfolio. The probability of negative returns was also significantly reduced.
If that doesn't sound like much, consider that if a superannuation fund of $100 million could achieve extra returns of 0.16% per annum, the result would be additional growth of $160,000 per annum, for less risk. Compounded over time, this would make a significant difference to members' savings.
The author's warn, however, that "the performance of covered call strategies will depend on the market conditions prevailing over the holding period of the strategy.
This is the second study that has found that covered call writing can result in an increase in the return of a portfolio while simultaneously reducing the risk. Earlier research from SIRCA found that using a buy-write strategy (that is, writing covered calls) over the S&P/ASX 200 over the 14 year period studied would have produced returns 2.24% per annum higher for less risk than those produced by simply investing in S&P/ASX 200 Accumulation Index.
The buy-write strategy appears to be an exception to the higher returns, higher risk rule of investing - this is because the selling of calls over a long stock position raises premium income while at the same time reducing the volatility of the portfolio.
Michael Roche, ASX executive general manager of market services, says the UTS study shows that equity options are a very useful tool in the management of superannuation assets.
"Most superannuation funds have a diversified balanced portfolio similar to that studied by UTS, and there is now clear evidence that the risk-adjusted returns can be improved by employing a covered call strategy. This relatively modest enhancement of annual investment returns, which is achieved at a lower rate of risk, can be extremely significant for superannuation funds when compounded over many years."
Michael Saba, a senior derivatives analyst with Goldman Sachs JBWere welcomes the research.
"It underscores industry evidence on options strategies that clients have been executing in the market over recent years. Many fund managers concerned about lower returns in the market have been using these types of options strategies to enhance returns without adding additional risk to the portfolio; in fact risk is reduced, as shown in the report… We know that in reality these strategies really do work, and Goldman Sachs JBWere regularly provides institutional clients with this kind of industry based research as well as daily trade identification."
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