STK: Hedging And Yield Spread Analysis

Summary

• The Columbia Seligman Premium Technology Growth Fund follows a covered call strategy on the S&P North America Technology Sector Index.
• The strategy uses rules-based call option writing designed to seek capital appreciation, provide current income, and mitigate downside volatility.
• This article performs a closer examination of the fund in terms of income, growth, and volatility to further examine its pros and cons, and suggests a method for hedging some.
• This article also describes a method based on yield spread to gauge the short-term risks of investing in this fund at its current price, and the results show relatively thin margin of safety.

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Thesis

The Columbia Seligman Premium Technology Growth Fund (NYSE:STK) follows a covered call strategy on the S&P North America Technology Sector Index. The fund invests in 50-65 diversified technology companies across market capitalizations. At the same time, the fund also uses rules-based call option writing designed to seek capital appreciation, provide current income, and mitigate downside volatility. This article performs a closer examination of the fund in terms of income, growth, and volatility to further examine its pros and cons, and suggests a method for hedging some of the risks. The results show that the fund indeed has been delivering high income with a healthy appreciation. But its total return does not compare favorably against the underlying index, and it does not deliver low volatility either. This article suggests ideas for hedging some of the volatility risks.

Finally, this article also describes a method based on yield spread to gauge the short-term risks of investing in this fund at its current price, and the results show relatively thin margin of safety.

Basic information

The following chart summarizes the bare basic information of this fund for readers who are not familiar with it yet. It holds 50-65 technology companies with total assets of over $533M. And it charges a 1.15% expense ratio. As highlighted in the red box below, the current income distribution yield is around 5.5% and made quietly. As seen from the next chart, the holdings overlap quite a bit with the Nasdaq-100 index. These holdings are used to “cover” the calls that the fund writes, as to be elaborated later.

Source: CEF STK Fund description.

Source: STK fund description

Advantages: excellent income and hedge against market panic

As can be seen from the following chart, the STK fund indeed provided consistently high dividend income relative to the underlying index (represented by QQQ) since its inception. Its dividend started around 10%, and has been steadily declining to the current level. But even at its current level, it is still significantly higher than a simple technology index ETF fund such as QQQ. In 2020, the distribution was more than 10x of that from QQQ.

For readers who are not familiar with writing calls, here’s how it works in a nutshell. Writing a call is essentially selling an insurance. The seller (the STK fund in this case) receives a premium upfront. It is a strategy that receives a given amount of upfront gain – the key words here are “fixed amount” and “upfront”. The gain would not change no matter how the price of the underlying changes – and we will see its implication later, especially in the cons section. The gain was materialized upfront – meaning the fund gets to keep the gain no matter how the price of the underlying changes, and that is how/why the fund can keep paying high distributions consistently.

Just like selling anything, the amount of the premiums changes as the demand-supply dynamics change. When the market is in panic mode – like in 2020 – the demand for insurance is high, leading to an increase in the so-called implied volatility, and in turn leading to higher premiums for calls. That is the main reason why we see the spike of income distribution in 2020. Because of this reason, historical data have shown that writing calls can hedge market panic to some degree in the form of distribution yield.

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Source: Seeking Alpha

Disadvantages: limited upside for total return and some volatility

As can be seen from the next chart, the overall return of STK is respectable, 15.9% CAGR since its inceptions. But when compared to the underlying index, it is lagging by quite a bit, 1.9% vs 20.8%. The fundamental reasons are as aforementioned.

Selling a call is essentially selling an insurance. The seller (the STK fund in this case) receives a given amount of premium payment upfront – which is the total gain that can be achieved. The gain would not change no matter how the price of the underlying changes. Therefore, selling calls is a strategy that has a limited upside built in at the root level. And this limitation is clearly displayed in the chart below. It does not matter to the STK fund when the underlying index went through a long bull market. The STK fund only gets to keep the premium collected on the calls sold.

The next chart shows that the STK fund still suffers some volatility risk despite the panic hedging mentioned above, actually more than QQQ. As seen, the fund suffered more volatility than QQQ in terms of max drawdown, and it is correlated to the overall US market to the same degree as the underlying. Although its standard deviation is significantly lower than underlying partly due to the panic hedging mechanism.

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Yield spread analysis

For a bond-like equity fund such as STK who pays regular dividends, a major indicator I rely on (and fortunately with good success so far) has been the yield spread, i.e., the dividend yield minus the 10-year treasury bond yield. The spread also provides a measurement of the risk premium investors are paying. A large spread provides a higher margin of safety, and vice versa, and therefore serving as a market timing indicator.

The following chart shows the yield spread between STK and the 10-year Treasury. The yield spread is defined as the TTM dividend yield of STK minus the 10-year treasury bond rate. As can be seen, the spread is bounded and tractable. The spread has been in the range between about 6% and 10% the majority of the time. Suggesting that when the spread is near or above 10%, STK is significantly undervalued relative to 10-year treasury bond (i.e., I would sell treasury bond and buy STK). In other words, sellers of STK are willing to sell it (essentially an equity bond) to me at a yield 10% above the risk-free yield. So it is a good bargain for me.

And when the yield spread is near or below 6%, it means the opposite. Now sellers are demanding such a high price that drives yield to be only 6% above the risk-free yield – which makes little sense to me as a buyer. Remember that selling a call is selling an insurance – the seller gets paid a fixed amount to assume the risks associated with the price movement of the underlying. When the spread between the premium is too thin compared to risk-free treasury, I’d rather just hold treasury.

Such spread analysis provides a method to gauge the risks (especially in the near term), and it also opens up opportunities for dynamic allocation to benefit from the price movement in the short- to mid-term with good reliability, as seen in the next chart below.

Source: Author based on Seeking Alpha data

The next chart shows the two-year total return on STK (including price appreciation and dividend) when the purchase was made under a different yield spread. As can be clearly seen, first that is a positive trend, indicating that the odds and the amount of total return increases as the yield spread increases. More specifically, the correlation coefficient is 0.56. For readers that are not familiar with the correlation coefficient, it is a number between -1 and 1. When it is 0, it indicates that there is correlation between two variables (in this case, yield spread and return, respectively). And 1 indicates a perfectly positive linear correlation between two variables. And a correlation near or about 0.75 is usually interpreted as a strong positive correlation between two variables. The 0.56 correlation in this case suggests a mildly strong correlation. Particularly as shown in the orange box, when the spread is about 10% or higher, the total returns in the next two years have been all positive and very large (all above about 40% and ranges up to ~60%).

As of this writing, the yield spread is 4.2%, close to the thinnest level of the historical spectrum even when the 10-year yield is as low as 1.3%, suggesting a thin margin of safety for short-term market timing. Such thin margin was driven by several factors: the long bull market, the near historical record level of high valuation of the technology sector, and the relatively low implied volatility in the options market. Any change in these factors (10-year treasury rate, fundamental valuation, and implied volatility) could cause short risks.

Source: Author based on Seeking Alpha data

How to hedge some of the volatility and risk?

With the above understanding of the volatility risks and short-term uncertainties, this section discusses some ideas that could help to tame some of the volatility and risks. First, a little bit more about my overall portfolio management strategy and my stock selecting methodology. At the portfolio level, I follow a variation of Dalio’s All Weather Portfolio. And the central idea in my asset allocation is diversification. There are not many truly diversified investments (i.e. uncorrelated investments) available to most investors. And as seen from the chart above, STK is correlated to the overall US technology sector to a high degree.

However, STK is negatively correlated to long-term treasury bond as seen below, and shows almost no correlation to gold. Such negative/low correlation opens an opportunity to build a risk-parity portfolio, as illustrated next.

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

A risk-parity portfolio combines the use of two or more negatively correlated assets, such as long-term treasury bond and gold with STK in this case to reduce volatility. The following examples illustrate the idea by two simple portfolios:

Portfolio 1: 100% STK

Portfolio 2: 90% STK + 10% EDV

Portfolio 3: 90% STK + 10% EDV + 10% GLD

As can be seen in the next two charts in this section, with the addition of only 10% EDV and 10% gold, the combined portfolio significantly reduced the volatility, in terms of the standard deviation and the maximum drawdown. And at the same time, it generated a slightly lower total return – thought not by that much, no more than 1.5% CAGR.

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Conclusions and final thoughts

The Columbia Seligman Premium Technology Growth Fund follows a covered call strategy on the S&P North America Technology Sector Index. This article performs a closer examination of the fund in terms of income, growth, and volatility. The results show that the fund indeed has been delivering high income with a healthy appreciation. But its total return does not compare favorably against the underlying index, and it does not deliver low volatility either.

This article also describes a method based on yield spread to gauge the short-term risks of investing in this fund at its current price, and the results show relatively thin margin of safety. As of this writing, the yield spread is 4.2%, close to the thinnest level of the historical spectrum even when the 10-year yield is as low as 1.3%, suggesting a thin margin of safety for short-term market timing.

Finally, with the above understanding of the volatility risks and short-term uncertainties, this article discusses some ideas to hedge some of the risks based on diversification and risk-parity. Adding a small portion (say 10%) of safe-haven assets such as treasury bond and gold could significantly reduce the volatility during turbulent times.

Thx for reading and look forward to your comments!

Analyst’s Disclosure: I/we have a beneficial long position in the shares of EDV, QQQ either through stock ownership, options, or other derivatives. 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.