Every once in a while an investment comes along that makes you go "no duh, why didn't I think of that?" The idea is so common sensical you find it amazing that it took so long to make it to market. Pick up any Finance or Economic Text book and it will highlight how gold is a difficult asset to value because:
1) It has limited usefulness as an industrial metal.
2) It doesn't pay dividends and costs money to store.
3) Its main use is as a hedge against inflation or a safe haven store of value in case of a financial collapse.
Personally I find gold an awful investment, don't own it, wouldn't recommend it and believe the foundation of its lofty price is fear of a total financial collapse and a misunderstanding of the Federal Reserve and its monetary policy. If you ask me, the value of gold is mostly based upon fear, and that isn't a solid foundation for a long term investment. In my opinion, I would rather own bullets and guns than gold if we ever do fall into Armageddon, and there are simply far better investments to use if your goal is to hedge against inflation like inverse bond funds.
So, I've made it clear that I do not recommend investing in gold at this time. I do recognize however that many many many people disagree with me on this issue, so if I were to recommend gold, I would recommend investing in SPDR Gold Trust (GLD) and write covered calls off of the holding. That way an investor can generate income off of their gold holdings. Because of my interest in that strategy, I was immediately interested in the new Gold Shares Covered-Call ETN (GLDI). I thought I would finally have a gold investment I could recommend to people interested in GLD. Unfortunately, after analyzing this security, I was completely disappointed.
The problem with GLDI is that it "sells approximately 3% out of the money notional calls each month while maintaining a notional long position in GLD shares (view Fact Sheet)." The problem with this strategy is that GLD often has monthly returns far greater than 3%. Out of the 101 option months (3rd Friday to 3rd Friday) of data on GLD, it had returns greater than 3% 38 times. That means over 1/3rd of the time, GLD would be trading in the money at the end of the month and possibly being locked out of gains. The following graph highlights the options month return distribution ranked lowest to highest. The black line is 3%, and the blue arrow spans all monthly returns greater than 3%. (Note: if you look up the monthly gains for GLD they will not match this graph, this graph is for option months, not calendar months)
Currently, GLD trades at $154.47, 3% above that is $159.10. The option 4 weeks out, the April 26 call with a strike price of $159, trades for $0.44, or 0.28% of $154.47. Basically investors in this fund are getting paid 0.28%/month to give up any returns greater than 3%. The following chart compares the performance of GLD verses its return with a monthly cap of 3.50%. I'm using 3.50% because option prices vary from month to month, and gold has been relatively stable and falling lately which would result in low call prices. If gold had been in a strong uptrend like it has been in past, the options income would have likely been higher, so this example will have a return greater than what it would be had I used the current month's options prices, but is most likely more representative of an average monthly return.
GLD dramatically outperforms GLD with a 3.5% cap. Over the time period measured, $1 invested in GLD grew to $3.44. That same $1 invested in the 3.5% cap portfolio grew to only $1.14. By limiting the monthly return to 3.5%, the capped portfolio was locked out of substantial gains, but with the options income providing minimal downside protection, basically participated fully on the downside. It simply is an awful strategy, especially when executed during a bull market in gold. Looking forward, if GLD enters a bear market, the option strategy will most likely work better, but applying it to past history, it performed very poorly.
The reason for this is obvious, the portfolio designers chose to use a fixed percentage return. That may seem like an obvious approach at first, but it is a fatal error. GLD is way too volatile to apply a 3% cap. Over 1/3 of the option month returns exceed that amount, some by as much as 14%. A properly designed portfolio would have used a 3 standard deviation envelope on some other strategy based upon a return distribution, not a linear and static 3% envelope. In fact when I first read the news article on this ETN, I assumed the author had made a mistake, and double checked to verify that the 3% was accurate.
If the portfolio had implemented a 3 standard deviation cap + 0.50% for the options, the performance would have been dramatically different, but still would not have beat simply being long gold. During the period studied, $1.00 invested in GLD would have grown to $3.31, the 3.5% cap would have grown to $1.13 and the 3 standard deviation + 0.50% cap would have grown to $1.87. (Note: I used a 12 month standard deviation, so the time period covered does not match the value of $1 calculation above)
Over the 7.4 years represented by the above graph, GLD had an annualized return of 17.6% and a monthly standard deviation of 5.87%. The 3.5% cap portfolio had an annualized return of 1.7% and a monthly standard deviation of 4.12% and the 3 standard deviation + 0.50% portfolio had an annualized 8.8% and a monthly standard deviation of 4.72%. Even on a risk adjusted basis, simply being long gold was the best alternative. Second was the 3 standard deviation + 0.50% and last was the 3.5% cap portfolio. It is important to note however that the time period covered was a strong bull market in gold when covered call strategies would be expected to underperform. The opposite would be expected in a strong bear market (as long as there aren't strong counter trend rallies).
In conclusion, covered call writing strategies are great for generating income if they are applied to the correct investments. Gold and other investments that are in strong uptrends, have highly variable monthly returns and sizable counter trend rallies and corrections make implementing such strategies much more difficult. From the analysis presented above, the strategy GLDI follows does not seem to deliver solid results when back tested. That does not however mean it will not perform better if gold enters a bear market. In my opinion, investors in gold would be better served by simply implementing their own covered call strategy, selling calls into strength when the premiums are greatest and the probability of reaching the strike price is lowest. That strategy however requires continual monitoring, and doesn't lend itself to a simple explanation like a 3% envelope does. If a simple model is desired, using a 3 standard deviation envelope adds substantial value over the 3% model when back tested during a bull market, but still underperformed simply being long gold. The results may be reversed however in a bear market. If an investor in gold seeks to generate income and implement a covered call strategy, it is important for them to understand when these strategies work, and when they don't, and tailor the strategy accordingly. Securities like GLD that have periods of calm followed by storms where it may have a series of small monthly gains or losses followed by either a double digit gain or loss do not lend them to a static call writing strategy. The reason for this is because during the calm, the premiums evaporate on the calls providing the call writer little protection from the storm, and all that happens is the investor gets locked out of solid gains during the strong rallies. Because call writing on GLD is so difficult and complicated, it now becomes obvious to me why it has taken so long to bring an ETN to market that implements this strategy, in my opinion a simple solution or model still has not been found.
Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.