Covered calls become another alpha source

NEW YORK — Covered call strategies are not just insurance for portfolios anymore, they are becoming sources of alpha.

For return-starved plan sponsors facing rising liabilities, weak expected returns from the equity and bond markets and a flat yield curve, a new source of excess return would be welcome news.

Research from Goldman Sachs & Co., New York, and the Chicago Board Options Exchange shows that covered call strategies, also known as buy-write strategies, can deliver stronger long-term risk-adjusted performance than long-only investing. But few pension plans — burned by buy-writes in the 1990s — are willing to engage in the strategy, in which an investor purchases a stock or index and simultaneously writes a call option on it.

Jason Ungar, director of Ansbacher Investment Management Inc., New York, which actively manages options, said pension executives should look at covered call strategies as a form of enhanced indexing. The 2-year-old firm manages about $200 million in buy-write strategies. He said covered calls are a better option than futures-based enhanced index strategies that seek to deliver excess return via a fixed-income portfolio, such as Newport Beach, Calif.-based Pacific Investment Management Co.'s popular StocksPLUS fund.

"Plan sponsors don't want to write call options, but they are investing in portable alpha strategies that make crazy yield curve plays," said Mr. Ungar. "Predicting the yield curve isn't possible."

The StocksPLUS fund seeks to gain excess returns over the Standard & Poor's 500 stock index via a fixed-income portfolio that uses carry trades. Its performance has suffered in the past few years because using carry trades is not effective in a flat yield curve environment (Pensions & Investments, July 25). In 2005, the fund returned just 3.2%, a far cry from the 29.6% return it notched in 2003

Mohammed Riad, managing director and senior portfolio manager at Fiduciary Asset Management Co., St. Louis, which manages $4 billion in covered call strategies, agreed with Mr. Ungar that a covered call could be considered a form of enhanced indexing. "While covered call writing is being managed more as a quasi-enhanced index product now, the risk characteristics of it are different from long-only investing," he said.

Two pension plans known to use buy-write strategies are those of General Dynamics Corp., St. Louis, and SKF USA, Trooper, Pa. According to the 2006 Money Market Directory, General Dynamics actively manages about $3 billion of its $12.5 billion defined benefit plan in covered call strategies. The $600 million SKF plan began applying buy-write strategies last year (P&I, May 16). Officials from neither of the two funds returned calls seeking comment.

Money managers noted that in the past, pension executives saw covered calls as a way to stem downside risk. But users got burned when the bull market began in 1995.

Joanne M. Hill, managing director of equity product strategy at Goldman Sachs and the main author of the firm's research on covered call strategies, said things are different now. "In the mid-1990s, the focus of buy-write strategies was that most of them were done by selling ‘at-the-money' options, and it was being done on an overlay basis. The managers often did not have control of the underlying stock (as they do today). When the markets rallied in 1995… they had to go to their clients and get the money and ask for a cash payment. Also, back then the expectations were not in terms of total return."

An "at the money" call option means that the strike price is the same as the price of the underlying security or index, and an "out of the money" call option means that the strike price is higher then the value of the underlying security or index.

Lawrence Tint, chairman of Quantal International Inc., a risk management firm in Berkeley, Calif., and a former Barclays Global Investors vice chairman, said his firm has developed a covered call strategy that writes call options on single names, rather than an entire index.

"In the past you would have used a call-writing strategy on an index fund," said Mr. Tint. "If you selectively write calls on individual stocks in an index, rather then writing on that index as a whole, you can improve the risk/return characteristics of the portfolio in a more significant way. So in that sense, you're creating an alpha."

According to a Feb. 28 research report issued by Goldman Sachs, an investor using a buy-write strategy and writing 2% out of the money monthly call options on the S&P 500 earned an average annualized return of 13.55% between Jan. 1, 1995, and Dec. 31, 2005, with a standard deviation of 10.38%. Over the same period, the S&P 500 index returned an average annualized 11.05% with a standard deviation of 14.08%.

The Chicago Board Options Exchange, in a research report earlier this year, found that the annualized return of its new BXY index — a benchmark composed of hypothetical 2% out of the money call options on the S&P 500 — produced an annualized return of 12.7% and a standard deviation of 11.3% between Jan. 1, 1988, and Feb. 28, 2006.

Louis Finney, director of research at Mercer Investment Consulting, Chicago, cautioned that investors must be aware that they could potentially be giving up returns if the markets spike. "I'm not against managers using call options. But what I tell clients is that writing a call option can give you a little bit of money now, but in return, you could be selling the upside later."

Goldman's Ms. Hill also noted that covered call writers benefit because buyers of call options, on average typically expect the market's volatility to be higher than what it actually will be – a fact that is proven by the Chicago Board Options Exchange's VIX index measuring implied volatility of the S&P 500 index.

Matthew Moran, a vice president at the CBOE, said in the long term, a covered call strategy may pay off, but added: "If you think the market is going to go up by 30% to 40% per year, generally this strategy will not keep up. But in using this strategy, it's like you're giving up the potential for a home run for a lot of singles and doubles."