Covered Call Strategy Can Reduce Volatility for Pensions

Horizons ETFs Management (USA) LLC launched the Horizons S&P Financial Select Sector Covered Call ETF.

The exchange-traded fund (ETF) uses a covered call strategy designed to potentially generate additional income from the option-eligible stocks in the S&P Financial Select Sector Index. Horizons USA has an exclusive agreement with S&P Dow Jones Indices LLC to offer an ETF in the U.S. based on the Underlying Index.

The fund generally owns all the securities of the Reference Stock Index, in substantially similar weights to the index, and will sell or “write” covered call options on up to 100% of each of the individual option-eligible securities in the portfolio. A covered call is an options strategy whereby an investor holds a long position in an asset and sells or “writes” call options on that same asset in an attempt to generate more income (the additional income from option premium) than the asset would otherwise provide on its own from dividends or other distributions.

“U.S. stocks have been a great place to be invested over the last two years,” says Howard Atkinson, managing director of Horizons USA. “Some Investors may feel that now is a good time to be looking at more defensive strategies to preserve some of their returns. A covered call strategy can keep you invested in equities and potentially lower the volatility of returns of those equities while attempting to generate additional income, which can mitigate losses, during certain market conditions.”

Generally speaking, a covered call strategy would be used quite differently for a defined benefit plan than it would for a retail investor portfolio, Horizons ETFs told PLANSPONSOR.

In retail portfolios, the primary focus of the buy-write strategy is to generate excess income. Defined benefit plans need to have a certain level of certainty around the income they generate, particularly if they are running a liability driven investment (LDI) strategy. 

However, the company says, covered calls can still be a valuable alpha generation strategy for a large pension plans because they can reliably reduce the volatility of the returns of the stocks. Most pension managers are concerned about risk rather than returns. Over long periods of time, an out-of-the-money option strategy, like the one utilized by the newly announced ETF, tends to generate returns that are more or less in line with an equity benchmark. It can substantially reduce the downside risk, since they tend to generate the highest amounts of option premium during periods of high volatility. According to the company, covered call strategies tend to outperform traditional stock strategies during periods of market impairment when volatility is at its highest.

Horizons ETFs adds that the equity portion of the pension portfolio will therefore have a "smoother" return trajectory and over very long periods of times, out-of-the-money call options have been shown to actually outperform the S&P 500 through a full market cycle.

In addition, the company told PLANSPONSOR, historically options strategies have been expensive to implement on an institutional scale—usually requiring an actual in-house options team. The new fund has a management fee of 0.75%, and the existing Horizons S&P 500 Covered Call ETF has a management fee of only 0.65%, making them appealing to cost-conscious institutional investors that don’t have in-house options capabilities.

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