The concept behind the PowerShares S&P 500 BuyWrite Portfolio ETF (NYSEARCA:PBP) is a good one. Buy a bunch of S&P 500 stocks and write out-of-the-money covered calls with nearby strike prices against those stocks, month after month. Selling covered calls can be a great way of juicing portfolios with a little extra income generation when used on their own.
Inside a hedged equity ETF like PBP, the goal seems to be long the market, but to hedge overall risk by selling the calls. This limits upside if the stock is called away, and can cause the fund to "miss out" on some upside. It hedges downside a bit if calls are sold but the stock falls.
However, if you are looking to add a strategy like this to your portfolio (as opposed to just investing in an ETF that covers the S&P 500), there are better ways to go. You can do it yourself.
Because the ETF is limited to S&P 500 stocks, and it is a relatively mechanical model, it does not allow for that special individual knowledge that investors can bring to the same strategy. Most investors likely have a basket of stocks they have followed for many years, but even if they don't, a simple options screening program can show opportunities for the same strategy can yield far better results.
With PBP, there is a major limitation to its strategy. You are locked into the S&P 500. The stocks in that index may not always be - and in fact, usually aren't - relatively flat. That's when covered calls offer the best result. Remember, you are selling the right for someone to buy the stock from you at or above a particular strike price. You'd rather the stock not get called away so you can hold it AND collect the sales premium. There are so many stocks that PBP is selling covered calls against that shouldn't have covered calls sold against them at that particular time.
You can do better. First, look at the basket of stocks you have been watching. Certainly, you've noticed patterns. Use that to your advantage. If that's not something you do, then stocks that work best with covered calls are stocks that you wouldn't mind owning in the long term. For me, those are stocks that have the best chance of long-term success - those with 1) strong free cash flow, 2) a PEG ratio of 1.0, to make sure you are not overpaying for a stock, 3) large cap stocks that tend not to move too much outside of earnings season, and 4) occasional mid-cap or small-cap names that I believe are undervalued.
Selling covered calls against these stocks will yield better results because you can choose when to sell calls instead of having those covered call sales forced upon you by PBP.
Here's a look at how the CBOE S&P 500 BuyWrite Index (which is essentially what PBP mirrors) did compared to the S&P 500 itself.
Image courtesy of PowerShares website.
As you can see, its performance is erratic. While it initially seemed to capture much of the upside of the S&P 500, it has since only captured about a third of the upside. Obviously, in years like 2015, when the market was mostly flat, PBP outperformed slightly. If stocks are flat, covered call sales will generate premiums but be less likely to get called away.
However, in years where the market is negative, the underlying stocks will be falling and selling covered calls will only blunt some of the damage.
Yet when you examine the average annual returns from PBP, they are pretty abysmal.
Image courtesy of PowerShares website.
A 2.64% annualized return? That's awful. Frankly, not since 2009 has the PBP put up numbers worth celebrating about, except perhaps for 2013. Investors who take an active role in their own buy-write strategy can easily outperform the PBP, provided they know the stocks that work best for this strategy.
I've followed many stocks over the years and have been using this exact same strategy. I'll share with you a few stocks that you can sell covered calls against just three times each year and beat the 2.64% return of the PBP.
But these aren't just any stocks. These are stocks that, if the stock isn't called away or if they decline, you should hold on to them long term. That's the key with this strategy - don't buy a stock you don't want to get stuck with.
AT&T (NYSE:T) is a great choice because it stays within a tight trading range, has great cash flow, and is not a company that's going to vanish tomorrow or any day. On Wednesday, it closed at $43.10. Selling the July 22nd $43.50 calls gets you $0.45, or 1%. Do that twice more in the next year, or even more, and you'll handily beat the PBP.
McDonald's (NYSE:MCD) is a great example. The stock and company had stumbled but I kept selling covered calls even as the stock fell. I kept buying the stock back when the stock was called away as it rose to its former prominence. Now that MCD is in the midst of a successful turnaround, it is a great stock to sell calls against, and the path of least resistance is up. McDonald's is recession-proof and does even better when times are good. Wednesday's close was $120.63. You can get $1.10 for the July $121 calls, or 0.9%. Do that three more times in the next year at a minimum and beat the PBP.
I love Amgen (NASDAQ:AMGN) for covered calls because it is a reliable cash flow machine. It's also been in a trading range for the past two years. The stock is at $156.05. The July 22nd $157.50 calls are selling for $1.90, or 1.15%. Sell two more calls at a minimum to beat the PBP.
If you want to take a bit more risk and try for higher returns, consider selling calls against Expedia (NASDAQ:EXPE). There is more near-term risk in that Expedia is subject to earnings report volatility. However, you can get a fantastic premium before Expedia even reports earnings by selling the $106 covered calls against Expedia stock, which closed at $106.20 on Wednesday. You collect $2.35 net, or 2.35%, matching PBP in one fell swoop.
Also note that these are all options that have but a two-week time frame. Since most options have four-week time frames, you should do even better on your next set of sales and beyond.
There's no reason to pay a 0.75% expense ratio for an underperforming buy-write ETF. Do it yourself.
Disclosure: I am/we are long MCD, AMGN, T, EXPE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.