Income Lab Ideas: Exploring Option-Strategy Performance Drag
Summary
- Generally, an option strategy works best when the market is trending sideways or slightly down.
- In a market that generally trends in an upward manner, an option strategy will have a 'drag' on performance.
- We are looking to quantify this drag so we can better understand what to expect from our funds that utilize an option strategy.
- This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Get started today »
Co-produced by Stanford Chemist
The path to successful investing is starting out with understanding what you are owning in the first place. Of course, diversification can help in this respect as well! Today, we are going to be looking at several funds that utilize option strategies. These are all funds that utilize covered call writing on either individual stock holdings within their portfolio or on indexes to help generate premium. The more advanced CEF investors may already know that an options strategy tends to actually have a drag on performance over time. For those that are newer to CEFs, this may be surprising to find out! This is exactly what we are looking to quantify in today's piece, which is how much of a 'drag' an options strategy can have overall on a fund.
When I reference a 'drag' on performance, all I am referring to is the fact that the strategy will generally lag the underlying index. Why is that with options? Well, simply put, the market has an upward trend in general. This means the funds utilizing these strategies, especially in the case of index options, are having to purchase back the options contract at a higher price than the premium they received to close out the position. Additionally, on index options, there is a theoretical infinite loss potential as an index could go to infinite. Of course, this won't happen, but the higher the index goes the higher the loss potential. This is offset by the underlying holdings in the portfolio that would also likely be rising in tandem with the upward movements of such an index.
So far this sounds like an option fund doesn't have a place in a portfolio since they are losing money through this strategy. Of course, that isn't true either. Option funds do have a place in a well-rounded portfolio. In a sideways to slightly downmarket these option strategies can be just what is needed to get that little bit of extra juice out of the portfolio - or enough premium to offset some small losses in the portfolio.
Additionally, there is a huge tax benefit in the form of deferment for tax liabilities that some option funds utilize. The fund sponsor that seems to be the most prolific in this regard is the Eaton Vance funds. Essentially, the return of capital that is paid out defers taxes via the reduction in cost basis and is not taxable until the investment is sold. To take this a step further, one could potentially never sell and let heirs take the benefit of a step-up basis. The caveat here is that if the cost basis is reduced to below $0 - then tax obligations will come in the form of a capital gains tax. We explore this further in a prior publication on the 'benefits' of ROC though, so we don't have to go at length in this piece.
There are 7 funds that we will be using as the case study for today. They have various strategies like single or index option contracts, U.S. vs global exposure and different targeted overwritten allocations. We also chose names from several different fund sponsors to highlight that such a 'drag' isn't limited to one or the other. The relevant information will all be included in the tables we explore further below.
(Source)
The Funds Included In This Exercise
BlackRock Enhanced Dividend Trust (BDJ) - a position in our Income Generator portfolio. BDJ has an inception date of 8/26/2005.
BlackRock Enhanced Capital and Income (NYSE:CII) - another Income Generator position. CII has an inception date of 4/27/2004.
Eaton Vance Tax-Managed Diversified Equity Income Fund (ETY) - this is a position in our Taxable portfolio. ETY has an inception date of 11/27/2006.
Voya Global Advantage and Premium Opportunity Fund (IGA) - this name is held in our Income Generator portfolio. IGA has an inception date of 10/26/2005.
Eaton Vance Tax-Managed Global Buy-Write Opportunity Fund (ETW) - a position held in our Taxable portfolio. ETW has an inception date of 9/28/2005.
BlackRock Enhanced Global Dividend Trust (BOE) - this position is held in our Tactical Income- 100 portfolio. BOE has an inception date of 5/26/2005.
BlackRock Enhanced International Dividend Trust (BGY) - this name is not held at the CEF/ETF Income Laboratory in any of the three portfolios. BGY has an inception date of 5/25/2007.
Quantifying The 'Drag'
In the following tables, we pulled the data from the 7 funds included in this exercise to see what gains or losses were generated from their options strategy. Following the tables on the funds, I will include a chart for the SPDR S&P 500 ETF (SPY). The chart will be used to give us an idea of what the overall broader market was like in the relevant years. Of course, the various CEFs have different reporting periods so we will primarily be looking at the years of 2018, 2017 and 2016. This doesn't include 2019's performance because we are still waiting on many of the funds to report for this time period.
I believe this still gives us quite a diverse mix of performances; we have 2016's 12% return for SPY, then 2017's excellent 21.71% return and then 2018's -4.57% let down. It is also important to consider that these funds are not expected to outperform the SPY, as that is not the goal of them. They will lag SPY as they utilize a covered call option strategy. A few of the highlighted funds also have global exposure too. So again, their benchmark is not the S&P 500, and therefore, the performance isn't exactly what we are looking at. The factor we are looking at is to what extent the option strategy was a 'drag' on the performance.
The final row, percentage gain/loss is calculated by using the reported net realized gain/loss of written options, basing it off of the percentage of current assets. This is our estimate of the amount of "drag" caused by the option strategy.
2018
(Source - Annual Reports, author compiled)
From the above period of negative returns for SPY, we can see that there were two funds that had a positive outcome from their options strategy. Those two funds would be ETW and BGY. The funds CII and IGA had an almost negligible performance from their options strategy. BDJ and BOE also weren't too harshly penalized for their options. Finally, ETY the U.S. focused fund that utilizes a written option strategy on indexes had a 'drag' of over 2% through the option strategy.
Overall, we see an average performance drag of -0.2814% when all 7 funds are combined. The global funds would have been the most benefited from the use of the option strategy, while ETY's performance really dragged the U.S. funds down with it. Important to note here that ETY's Annual Report was available as of October 31st, 2018. This is while the others were more reflective of 2018's performance, in general. This does skew our data a bit so it is worth pointing out. Additionally, 2018 was free of volatility relatively speaking, except when Q4's selloff really began to unfold.
2017
(Source - Annual Reports, author compiled)
We now look to 2017's spectacular SPY returns of ~20%. Again here we should note that ETY is reflecting more of 2018's returns than the other funds. In general, though, we see the drag that comes from a year with strong upward momentum!
The average drag from this period of time for the 7 funds reflected comes in at a steep -3%. For this period, none of the funds are showing a positive return from their options strategy. This is precisely what we would anticipate though with a strong overall period of broader market performance.
2016
(Source - Annual Reports, author compiled)
Finally, we can look at 2016's broader market performance. For what it's worth, this is still a strong performance from SPY. This is above the historical average that the S&P 500 produces around 8%. We again see that no fund had a 'successful' options strategy in this majority up-trending year. With that being said, the funds' average underperformances come in at -1.6% for this reporting period. In-line with what we would anticipate when running this excessive against the other periods.
2008 GFC
One may be curious to see how these funds had performed against the broader market during times of a massive selloff. In fact, the above funds all have inception dates pre-dating the Great Financial Crash so we are able to pull the data of returns from them.
Here again, we will use the SPY as just a barometer of the overall market performance and not as a benchmark. The above chart is reflective of the fund's total market returns.
This chart is now reflecting total NAV return performance relative to the broader SPY. It is interesting to note that all the funds highlighted beat SPY's total return, besides BGY.
You will also notice in the total market price returns the funds performed much worse in the majority of the funds than their NAVs. This is important to note as we typically see with CEFs overshooting to the downside and we get opportunities through wider discounts.
Just for fun and to reaffirm the above statement, we can take a look at the discount/premium charts for the funds during this time. The clear take away is that funds do experience a significant widening of their discounts during times of panic. Though, even the fund's discount/premiums levels appear to become quite volatile along with the rest of the market towards the end of 2008!
One other place I wanted to look at is the funds' Semi-Annual Reports again for this period. The BlackRock funds would have worked perfectly had their fiscal year-end been consistent with the calendar year-end. However, in 2014 is when they changed their year-end reports to match the calendar year. Prior to this, the fiscal year-ends were on October 31st. That is why we will look at the Semi-Annual reports.
ETW's fiscal year-end has not changed though, and this lined up perfectly with looking at 2008's numbers from that report. In that report, they reported a massive realized gain of $198,830,427. Why is this considered massive? This is because it was against assets of $1,340,802,912 - which equates to their options strategy returning almost 15%.
For BlackRock, the reporting period was for the end of April 30th, 2009, based on their prior October 31st fiscal year-end. For BDJ, we see that they reported realized gains of $27,282,793 against their $519,601,053 assets at that time. This was for a 6-month period and a slightly different reporting period than ETW. However, this still works out to a 5.25% gain from their options strategy.
BOE was showing a realized gain of $17,176,256. This was on assets of $197,134,503 equating to a gain of 8.71%.
BGY was at a gain of $62,033,301 on assets of $950,426,309, equating to a gain of 6.53%
CII had gained from their options strategy of $39,752,145 with assets of $564,461,082, working out to a gain of 7.04%.
With these numbers in mind, it is quite clear that the option strategies helped mitigate the worst of the drop!
2011
Another year that I wanted to focus on briefly is 2011, we saw a largely flat broader market for the year. 2011 is an important year when the market experienced a Black Monday - 2011 edition. On August 8th, 2011 markets plunged as the U.S. had a credit downgrade from AAA to AA+ by S&P.
The top chart is looking at the total market returns for 2011, while the bottom chart is looking at total NAV returns. Here I think it is incredibly important to look at just how weak the total market returns were relative to total NAV returns. This is most apparent when looking at the funds' discount levels throughout 2011. This was also during a period while the markets were still young in the fresh new bull market coming off of 2009's GFC lows.
We also see a massive underperformance in the global focused funds - while two of the U.S. based funds were showing some big beats! This is more a reflection of the deteriorating global equity market than it is for the funds' options strategies. This was helped triggered by an intensifying European debt crisis that was beginning to spiral out of control.
As previously mentioned, the market was still quite fragile during this time coming out of the greatest slump many investors in this lifetime had ever seen. The wide (and widening) discounts that we see during this period are likely reflecting the distribution cuts that all these funds were going through. I could just imagine that many investors at this time did not trust these funds. Quite a few of these highlighted funds only had an inception of a couple of years before the 2008/09 massive selloff. Thus, investors' sentiment was probably completely in the dumps at this point with these CEFs, after seeing share prices lose 50% or more.
Conclusion
In general, a CEF will lag or have a 'drag' of underperformance when utilizing an options strategy. The greater the returns of the overall broader market as measured by SPY sees an even greater lag in performance. However, option strategies really come in handy to help preserve the NAV of CEFs during times of panic. This is true even when the fund's market price may not be reflecting such a case! Again, this is where opportunity is created. The underlying 'loses' relative to NAV are mitigated by such options strategies.
While this is a huge benefit, this isn't the only benefit that option funds can create as we mentioned previously in the article. For a greater understanding of ROC, I would encourage you to take a look at one of our prior pieces exploring this subject more in-depth!
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This article was written by
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I provide my work regularly to CEF/ETF Income Laboratory with articles that have an exclusivity period, this is noted in such articles. CEF/ETF Income Laboratory is a Marketplace Service provided by Stanford Chemist, right here on Seeking Alpha.
Analyst’s Disclosure: I am/we are long BDJ, BOE, ETW, IGA. 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.
This article was originally released to members of the CEF/ETF Income Laboratory on February 1st, 2020.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (14)
As always enjoy your articles.
I own a number of option income CEFs and consider them a defensive portion of my equity portfolio.
I like the tax free ROC, that these funds turn STCG into LTCG (if I sell), the monthly compounding effect and if I leave these funds to my heirs they get a stepped up tax basis (hoping law doesn’t change).
BOE is an interesting stock. Full of staples and medical but it doesn't seem to suit and options strategy well since these stocks don't move much. CII would seem to perform better with tech stocks that can have broad swings. I think the Blackrock CEFs can really help for income. Leverage is great in a long bull, but now not so much.
I appreciate your coverage of CEFs. Most people want quick killer trades. CEFs are for the patient!