Download Options for Enhancing Risk-Adjusted Returns Covered Call

Exhibit 7
March 13, 2013
Options for Enhancing
Risk-Adjusted Returns
Covered Call Strategy
Jim McKee
Senior Vice President
Hedge Fund Research
John Jackson
Senior Vice President
Fund Sponsor Consulting
Exhibit 7
Options for Enhancing Risk-Adjusted Returns
Overview – Covered Call Strategy
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

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Purpose of Discussion
Strategy Defined
Pros & Cons
Historical Experience
Concluding Observations
Appendix
Knowledge. Experience. Integrity.
Exhibit 7
Covered Call Strategy - Purpose
Purpose of discussion
 Target allocation to equity assumes equity-like return over long-term horizon
 Review alternative equity strategy to deliver equity return with less volatility
– Complementary source of superior risk-adjusted return to equity exposure?
Knowledge. Experience. Integrity.
Exhibit 7
Covered Call Strategy - Defined
Covered call, or buywrite, strategy:
 Buy S&P 500 stock basket and sell, or write, call options* whose notional
exposure represents value of stock position
 Call option premium is kept by seller, but future upside return, if any, above
the “strike price” is earned by buyer
 Option premium cushions downside moves in an equity portfolio, but
subject to variability
 Buywrite strategies outperform stocks in neutral or bear markets, but
underperform stocks in bull markets
* A call option is the right (but not obligation) to buy a specific amount of an index or security at a specific price
within a specific time period.
Knowledge. Experience. Integrity.
Exhibit 7
Profit and Loss Expectations for CBOE S&P 500 BuyWrite Index
Option Premium

CBOE S&P 500 BuyWrite Index (BXM) – passive total return benchmark index
designed to track performance of a hypothetical covered call strategy:
– Purchase and hold an S&P 500 stock index portfolio
– Sell (or write) 1-month, at-the-money S&P 500 call options that are systematically
replaced in the following month with a new 1-month option
Knowledge. Experience. Integrity.
Exhibit 7
Option Premium – Sources & Variability of Returns
Sources of return embedded in at-the-money call option premium




Time until expiration - the longer the time frame until expiration, the greater the
chance that the option is profitable, thereby increasing the option value
Implied volatility (vs. actual or realized volatility) – the more volatile the stock price,
the more likely the option will be profitable over time, thereby increasing the option
premium
Interest rates - as interest rates rise, the call option’s value increases, since cash
spent on owning the underlying index is opportunity (interest) lost, thus increasing
the value of the option
Dividends - as dividends increase, call or option value decreases, since the option
seller (who owns the underlying security) collects the dividend, not the option buyer
Variability of return in covered call premium


Implied volatility is the primary driver in the short run
Average BXM premium* – 1.8% per month
* Source: www.cboe.com
Knowledge. Experience. Integrity.
Exhibit 7
Covered Call Strategy - Implementation
 The BXM Index was introduced in 2002
 Multiple products have been launched, both active and passive, to track the
BXM Index
Product
Vehicle
Fund Manager
Fee
Assets in Product
Inception Date
S&P 500 BuyWrite Portfolio
ETF (PBP)
Invesco
0.75%
$230 million (est)
December 1, 2007
iPath CBOE S&P 500 BuyWrite Index
ETN (BWV)
Barclays Bank
0.75%
$ 11 million (est)
May 22, 2007
 Some investment management firms have offered separately managed
accounts (SMA) designed to replicate the BXM Index
– Traction in the institutional marketplace has been limited. Some of the larger players
have $100-150 million within this strategy, but may also offer other option oriented
strategies.
– Fees for the SMAs are typically in the .20%-.40% range, thus more competitive than
the ETFs.
Knowledge. Experience. Integrity.
Exhibit 7
Pros & Cons of Covered Call Strategy
 Pros
–
–
–
–
Expected equity-like return with less volatility
Very transparent and liquid
Exchange-traded instruments – no counterparty risk
Income component of the option viewed as an attractive feature for some clients
 Cons
–
–
–
–
Significant upside participation may be lost, while involving cash flow management
Downside protection is relative, not absolute
High tracking error that invites criticism at most difficult time
Strategy often abandoned after its most difficult time (e.g., ‘96-’00; ‘03-’07)
Knowledge. Experience. Integrity.
Exhibit 7
Historical Experience – Cumulative Growth of a Dollar
Growth of a Dollar
(July 1, 1988 - December 31, 2012)
$8.99 - S&P:500
$8.71 - CBOE Buy Write Idx
$9
Growth of a Dollar
$8
$7
$6
$5.46 - BC Aggregate
$5
$4
$3
$2.50 - 3 Month T-Bill
$2
$1
8889 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
After almost 25 years, S&P 500 and BXM have similar cumulative returns
Knowledge. Experience. Integrity.
Exhibit 7
Historical Experience – Annualized Returns & Risk
Returns
Annualized Returns
(July 1, 1988 - December 31, 2012)
12%
10%
8%
6%
4%
2%
0%
9.24%
9.38%
7.18%
3.81%
CBOE BXM
S&P 500
BC Aggregate
3 Month T-Bill
Standard Deviation
Annualized Standard Deviation
(July 1, 1988 - December 31, 2012)
20%
14.86%
15%
10.56%
10%
3.78%
5%
0.71%
0%
CBOE BXM
S&P 500
BC Aggregate
Similar long-term return, but lower volatility
Knowledge. Experience. Integrity.
3 Month T-Bill
Exhibit 7
Historical Experience – Annualized Returns & Risk
Returns
Annualized Returns vs. Standard Deviation
for 24 1/2 Years Ended December 31, 2012
12%
10%
8%
6%
4%
2%
0%
0%
Callan Large Cap Core Style
CBOE Buy Write Idx
S&P 500
BC Aggregate
3 Month T-Bill
3%
5%
8%
10%
13%
15%
18%
20%
23%
Standard Deviation
Performance Statistics vs. S&P 500 for 24 1/2 Years ended December 31, 2012
S&P 500
CBOE Buy Write Idx
Callan Large Cap Core Style
BC Aggregate
3 Month T-Bill
Returns
9.38
9.24
10.46
7.18
3.81
Standard
Deviation
16.12
11.71
16.34
4.07
1.23
Sharpe Ratio
0.35
0.46
0.40
0.83
0.00
Tracking Error
0.00
7.48
3.96
17.80
16.53
Downside Risk
(vs. T-Bills)
10.57
7.99
10.53
1.85
0.00
Lower volatility, but significant peer group deviation
Knowledge. Experience. Integrity.
Exhibit 7
Historical Experience – Returns based on Rolling 5-Year Periods
Annualized Returns based on Rolling 5 Year Periods
From July 1, 1993 - December 31, 2012
30%
25%
20%
Returns
15%
10%
CBOE Buy Write Idx
5%
S&P:500
0%
-5%
-10%
93 94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
Five-year stretches of notable overperformance - and underperformance
Knowledge. Experience. Integrity.
Exhibit 7
Historical Experience – Risk based on Rolling 5-Year Periods
Standard Deviation based on Rolling 5 Year Periods
From July 1, 1993 - December 31, 2012
20%
CBOE Buy Write Idx
Standard Deviation
S&P:500
15%
10%
5%
0%
93 94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
Consistently less volatile, given less upside and downside participation
Knowledge. Experience. Integrity.
Exhibit 7
Historical Experience – Calendar Year Returns
Returns
Calendar Year Returns
40%
35%
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
-30%
-35%
-40%
37.6
33.4
31.7
30.5
26.6
25.0
24.4
21.0
28.7
28.6
26.026.5
23.0
21.221.0
19.4
18.9
14.1
11.5
10.9
8.3
10.1
7.6
4.0
15.8
13.3
15.5
7.4
4.2 4.9
4.5
16.0
15.1
6.6 5.5
5.9
5.7
5.2
2.1
1.3
-3.1
-9.1
-7.6
-10.9
-11.9
CBOE Buy Write Idx
S&P:500
-22.1
-28.7
-37.0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Worst year: -16.6% underperformance (1995)
Best year: +16.5% outperformance (2000)
Knowledge. Experience. Integrity.
Exhibit 7
Historical Experience – Returns in Rising/Declining Equity Markets
Annualized Returns for Domestic Equity Rising/Declining
g Periods
49.8
50%
40%
31.1
29.2
30%
30.7
30.7
26.2
23.1
21.2
20%
16.3
19.5
18.6 17.4
18.5
11.2
11.0 11.0
Returns
17.4
16.0
10%
0%
(10%)
(20%)
-2.5 -3.4
-8.8
-9.9
-9.3
S&P:500
-10.3-11.4
-11.7
-13.7
CBOE Buy Write Idx
(30%)
-8.0
-11.1
-13.9
-20.3
-20.6
-24.8
-33.5
(40%)
R: 7/1/88 D: 7/1/90
R:
D: 1/1/94 R: 7/1/94 D: 7/1/98
R:
D: 4/1/00
R:
D: 4/1/02 R: 4/1/03
D:
R: 4/1/09 D: 4/1/10 R: 7/1/10 D: 7/1/11 R: 10/1/11
to 6/30/90 to 9/30/90 10/1/90 to to 6/30/94 to 6/30/98 to 9/30/98 10/1/98 to to 9/30/01 10/1/01 to to 3/31/03 to 9/30/07 10/1/07 to to 3/31/10 to 6/30/10 to 6/30/11 to 9/30/11
to
12/31/93
3/31/00
3/31/02
3/31/09
12/31/12
“Decision risk” greatest in the wake of rising markets

BXM trails S&P 500 quarterly return almost half (47%) of the time from 1988 to 2012
Knowledge. Experience. Integrity.
Exhibit 7
Historical Experience – Returns in Rising/Declining Equity Markets
Annualized Returns for Domestic Equity Rising/Declining Periods
Group: CAI Large Cap Core Style
50%
B (35)
40%
30%
A (54)
B (69)
B (30)
A (59)
20%
Returns
B (57)
A (85)
B (38)
A (98)
(988))
A (98)
A (30)
B (45)
A (5)
B (56)
(10%)
(20%)
A (9)
B (46)
A (6)
B (51)
A (95)
A (99)
B (68)
A (97)
B (36)
A (36)
10%
0%
B (70)
A (10)
B (34)
A (1)
A (4)
B (23)
A (1)
B (58)
B (39)
(30%)
B (75)
(40%)
R:
D:
R:
D:
R:
D:
R:
D:
R:
D:
R:
D:
R:
D:
R:
D:
R:
7/1/88 7/1/90 10/1/90 1/1/94 7/1/94 7/1/98 10/1/98 4/1/00 10/1/01 4/1/02 4/1/03 10/1/07 4/1/09 4/1/10 7/1/10 7/1/11 10/1/11
to
to
to
to
to
to
to
to
to
to
to
to
to
to
to
to
to
6/30/90 9/30/90 12/31/93 6/30/94 6/30/98 9/30/98 3/31/00 9/30/01 3/31/02 3/31/03 9/30/07 3/31/09 3/31/10 6/30/10 6/30/11 9/30/11 12/31/12
CBOE Buy Write Idx
S&P:500
A
B
16.31 -8.76 18.57 -2.51 21.21 -8.01 26.17 -9.26 10.98 -11.67 11.17 -20.30 30.71 -10.26 19.52 -11.12 17.38
18.50 -13.74 17.40 -3.39 29.18 -9.95 31.15 -20.61 10.99 -24.76 16.04 -33.53 49.77 -11.43 30.69 -13.87 23.13
Challenge of covered call program is investor’s conviction or willingness to be
different from other active managers

46% of BXM’s quarterly returns are below that of median core equity manager
Knowledge. Experience. Integrity.
Exhibit 7
Covered Call Strategy – Concluding Observations
Recap




Target allocation to equity assumes equity-like return over long-term horizon
Covered call strategy – alternative to deliver equity return with less volatility
– Substitute for active or passive management in large cap equity
Appeal
– Attractive risk-adjusted return properties
– Very transparent and liquid, with exchange-traded instruments and no
counterparty risk
– Income component of the option viewed as an attractive feature for some clients
Concerns
– Significant upside participation may be lost, while downside protection is
relatively limited
– High tracking error that invites criticism at most difficult time, leaving strategy
vulnerable to abandonment after its most difficult time (e.g., fast-rising bull
markets)
Knowledge. Experience. Integrity.
Exhibit 7
Appendix
Knowledge. Experience. Integrity.
Exhibit 7
Glossary of Options Terms
At-the-money: An option is at-the-money if the strike price of the option is
equal to the market price of the underlying security.
Call: An option that gives the holder the right to buy an underlying instrument,
such as a stock or an index value, at a specified price for a certain, fixed
period of time.
Covered call option writing: A strategy in which one sells call options while
simultaneously owning an equivalent position in the underlying security.
Derivative security: A financial security whose value is determined in part
from the value and characteristics of another security, the underlying
security.
Exercise: To invoke the right under which the holder of an option is entitled to
buy (in the case of a call) or sell (in the case of a put) the underlying
security.
Exercise price (See Strike price): Exercise settlement amount. The
difference between the exercise price of the option and the exercise
settlement value of the index on the day an exercise notice is tendered,
multiplied by the index multiplier.
Expiration date: Date on which an option and the right to exercise it, cease
to exist.
In-the-money: A call option is in-the-money if the strike price is less than the
market price of the underlying security. A put option is in-the-money if the
strike price is greater than the market price of the underlying security.
Intrinsic value: The amount by which an option is in-the-money (see above
definition).
LEAPS®: Long-term Equity Anticipation Securities, or LEAPS®, are longterm stock or index options. LEAPS®, like all options, are available in two
types, calls and puts, with expiration dates up to three years in the future.
Margin requirement (for options): The amount an uncovered (naked) option
writer is required to deposit and maintain to cover a position. The margin
requirement is calculated daily.
Open interest: The number of outstanding options or futures contracts in the
exchange market or in a particular class or series. Refers to unliquidated
purchases or sales.
Option: The right, but not the obligation, to buy or sell an underlying
instrument, such as a stock, a futures contract or an index value, at a
specified price for a certain, fixed period of time.
Out-of-the-money: A call option is out-of-the-money if the strike price is
greater than the market price of the underlying security. A put option is outof-the-money if the strike price is less than the market price of the
underlying security.
Premium: The price of an option contract, determined in the competitive
marketplace, which the buyer of the option pays to the option writer for the
rights conveyed by the option contract.
Put: An option contract that gives the holder the right to sell an underlying
instrument, such as a stock or an index value, at a specified price for a
certain, fixed period of time.
Series: All option contracts of the same class that also have the same unit of
trade, expiration date and strike price.
Strike price: The stated price per share for which the underlying security may
be purchased (in the case of a call) or sold (in the case of a put) by the
option holder upon exercise of the option contract.
Time value: The portion of the option premium that is attributable to the
amount of time remaining until the expiration of the option contract. Time
value is whatever value the option has in addition to its intrinsic value.
Uncovered call writing: A short call option position in which the writer does
not own an equivalent position in the underlying security represented by his
option contracts.
Uncovered put writing: A short put option position in which the writer does
not have a corresponding short position in the underlying security or has not
deposited, in a cash account, cash or cash equivalents equal to the
exercise value of the put.
Underlying security: The security subject to being purchased or sold upon
exercise of the option contract.
Volatility: A measure of the fluctuation in the market price of the underlying
security. Mathematically, volatility is the annualized standard deviation of
daily price movements.
Writer: The seller of an option contract.
* Source: www.cboe.com
Knowledge. Experience. Integrity.
Exhibit 7
PutWrite Strategy
PutWrite strategy defined:




Purchase a portfolio of Treasury bills and sell, or write, put options* whose notional
value equals the Treasury bill portfolio’s market value
Put option premium is kept by seller, but future downside return, if any, below the
“strike price” is paid to the buyer from the Treasury bill portfolio
Option premium cushions losses from negative returns in the equity index, but
subject to variability
PutWrite strategies outperform stocks in neutral or bear markets, but underperform
stocks in bull markets
Passive strategy represented by CBOE S&P 500 PutWrite Index (PUT)
* A put option is the right (but not obligation) to sell a specific amount of an index or security at a specific price within a specific time
period.
Knowledge. Experience. Integrity.
Exhibit 7
Profit and Loss Expectations for CBOE S&P 500 PutWrite Index

CBOE S&P 500 PutWrite Index (PUT) – passive total return benchmark index
designed to track performance of a hypothetical put write strategy:
– Purchase and hold a portfolio of Treasury bills
– Sell (or write) 1-month, at-the-money S&P 500 put options that are systematically
replaced in the following month with a new 1-month option.
Knowledge. Experience. Integrity.
Jim McKee
SVP, Director - Hedge Fund Research

James C. McKee, Senior Vice President. Jim is Director of Callan's Hedge
Fund Research Group. Jim specializes in hedge fund research addressing
related issues of asset allocation, manager structure, manager search, and
performance evaluation for Callan's institutional clients. Jim is a shareholder of
the firm.

Jim joined Callan Associates in 1989. Prior to his career at Callan Associates,
Jim worked with the Pacific Stock Exchange (PSE) from 1982 to 1989. Until
1985, Jim worked on the PSE's options trading floor. Thereafter, as manager of
the PSE's securities research department, he was responsible for developing
and monitoring new stock, bond, and option listings.

Jim earned a B.A. in Economics/Environmental Studies from Dartmouth
College in 1982. He received his M.B.A. in Finance from Golden Gate
University in 1987. His graduate studies focused particularly on publicly traded
securities and capital markets.
Knowledge. Experience. Integrity.
Exhibit 7