Small cap stocks have done extremely well in recent years. Over the past twelve months, in particular, the Russell 2000 (IWM) is up 39.4%. The five-year annualized return for IWM is 21.1% and the ten-year is 9.2%. Obviously a large part of the longer-term performance is being driven by just the past twelve months, during which small cap stocks have benefited from general optimism and rising interest rates. Small cap stocks have historically performed well in rising rate environments and this year is no exception. On the other hand, small cap stocks have had an enormous run and they are generously valued, with a P/E of more than 29.
The problem for income investors, aside from the high current valuations, is that small cap indexes don't generate much income. The dividend yield of IWM is a paltry 1.5%. In addition, small cap stocks are volatile. The 3-, 5-, and 10-year volatilities of IWM are substantially higher than that of the S&P500. Small companies have their advantages, of course. First off, we have the small cap effect identified by Fama and French. Small cap stocks tend to out-perform large-cap stocks on a risk-adjusted basis.
One way to incorporate small cap stocks into an income portfolio is to pair them with income-generating assets. The small cap stocks provide the potential for price gains and increase the portfolio's tendency to perform well in a rising rate environment, and the income assets provide the yield.
A more direct way to utilize small cap stocks in an income portfolio is to sell covered calls against a small cap stock ETF such as IWM. This approach will tend to look most attractive when investors are bullish because there will be higher demand for call options. We are in just such an environment.
Today, IWM is trading at $112.30. You buy IWM and then can sell a call option on IWM with an expiration date of Jan 17, 2015 and a strike of $115 for $7.01. This is the actual bid price (what the market will pay)-not the mid-point price (which is halfway between the bid and ask). You are selling off all of the potential for price gains above $115, which leaves you a maximum price gain of 2.4% before the call strike is reached.
You have slightly longer than a year until this call expires (1.1 years to be specific). The effective yield of selling this call option is 5.65%:
Call yield = 5.65% = ($7.01/$112.30)/1.1 years
Now, the total annual yield for holding IWM and selling the call option is 7.15% (5.65% call yield + 1.5% dividend yield). This is a substantial yield, but what about risk?
There are several ways to estimate the future risk of IWM. One of these is to look at history. Over the past five years, my calculations are that the annualized volatility of IWM is 20.7%. Morningstar says 20.98%. There are two ways to estimate risk in the future, beyond simply looking at the past. First, we can use options quotes to estimate future risk. The implied volatility for the at-the-money put options on IWM is 22.9%. My Monte Carlo simulation puts the expected volatility at 20.7%. These numbers are all very close.
Over the past five years, the correlation between IWM and the 10-year Treasury yield is 34%. This means that IWM will tend to increase in price when bond yields rise, and bond yields tend to increase with expectations of higher interest rates. Over the past three years, the correlation between 10-year Treasury yield and IWM is 61%. If rates increase further and IWM continues to rally, your share of IWM will be called away. You have locked in the 5.65% call yield, however, which will soften the blow. If the shares are called away well before expiration, your effective call yield is higher.
How might we compare the risk, yield, and interest rate exposure from selling calls against IWM to other income asset classes? When I compare to individual income asset classes, the results looking compelling. DWX, the international dividend SPDR, yields 6.5% with projected volatility of 23.9% and a 3-year correlation to 10-year Treasury yield of 23.9%. This is the most similar single asset class to the IWM covered call strategy in terms of yield and interest rate exposure, but the IWM covered call strategy looks preferable on all measures.
A covered call strategy with IWM looks compelling if you can live with the fact that you are quite possibly buying near a top with the long position in IWM. By including an allocation to this strategy, however, you get a very respectable 7.15% income. In addition, this approach allows income investors to include an asset class that tends to end up with little or no allocation on the basis of dividend yield alone. From a tactical perspective, you are profiting from the current high enthusiasm for small cap stocks by selling the calls.
Additional disclosure: The primary ticker for this article is IWM