Tag Archives: pro

Understanding Covered Call CEFs

Barron’s recently had a favorable write up on closed end funds that one way or another use a covered call strategy as a means of providing income. The article proposes that volatile markets like now are a good environment for this niche and that the call premium can help mitigate the impact of large declines. I think both points are flat out wrong. The history here is that they do well in rising markets. By Roger Nusbaum, AdvisorShares ETF Strategist Barron’s recently had a favorable write up on closed end funds that one way or another use a covered call strategy as a means of providing income. Where the article focused on CEFs, the yields can be quite high because of the leverage that CEFs often use as well as returning capital, when necessary to maintain a payout. It is also worth noting that there are traditional funds that sell calls and ETFs that sell calls and puts too for that matter. I wrote about these quite a few times in the early days of Random Roger. The history of them shows long stretches where they do very well then long periods where they get pounded and then repeats. Based on chart below they got crushed in 2008 and the dividends were cut on many of them and neither the prices or payouts have recovered since. The article tries to make the case that volatile markets like now are a good environment for this niche and that the call premium can help mitigate the impact of large declines. I think both points are flat out wrong. The history here is that they do well in rising markets. The chart from Google Finance captures a whole bunch of them over a ten-year period. I removed the symbols for compliance reasons but finding funds in this space should be easy to do. If you play around with the time periods you will see they did very well in 2006 and far into 2007, 2009 well into 2010 and then a three year run from 2012-2014. As mentioned the got crushed during the bear market, did badly in 2011 and are having mixed results in 2015. (click to enlarge) I would have no expectation that these funds can buffer a stock market decline. These are income vehicles but they track the equity market higher to an extent (they correlate but don’t keep up) and I would bet they get hit hard in the next bear market but probably not as hard as 2008. Part of the equation in 2008 was a shutting down of bond markets which impacted CEFs in terms of accessing leverage. I don’t expect that to repeat but I would want sell in the face of a bear market as a 30% decline seems plausible for these funds in a down 40% world. Obviously there would be income vehicles to keep in a bear market but I don’t think these are one of them. Where they do well, then do poorly, they will do well again, maybe after the next bear market maybe sooner but anyone interested in this space probably needs to be willing to be tactical and be willing to sell after a period of their doing well. Interest rates have a very good chance of remaining inadequate for many years even if the Fed does hike rates this month. Attempting to be tactical is not right for everyone but I do think that the way investors get their yield will probably include market segments that require a more active and tactical approach.

AQR On Evaluating Defensive Long/Short Strategies

By DailyAlts Staff Heightened market volatility has many equity investors contemplating a move to defense. But in this environment, are defensive stocks too expensive to work? This is the question considered by AQR Principals Antii Ilmanen and Lars Nielsen and Vice President Swati Chandra in the November white paper Are Defensive Stocks Expensive? A Closer Look at Value Spreads . Value Spreads The paper’s authors begin by explaining the concept of value spreads: “Value” quantifies the “cheapness” of a long-only asset “relative to a fundamental anchor.” For a long/short style factor such as “defensive,” value spreads can be measured by comparing the value of the long portfolio (the most “defensive” stocks) to the value of the short portfolio (the least “defensive” stocks). When the style grows cheaper, the value spread “widens” – when the style becomes more expensive, the value spread “narrows.” Valuation and Strategies It only makes sense that a wide value spread is preferable to a narrow one, since a wide spread will (presumably) have the tendency to revert back to the mean, thereby “narrowing” and becoming more expensive (i.e., outperforming); while a historically narrow spread is more likely to “widen” and get “cheaper” (i.e., underperforming). AQR’s Cliff Asness and others have published research indicating that “over medium-term horizons, the future return on value-minus-growth stock selection strategies is higher when the value spread is wider than normal.” But Messrs, Ilmanen and Nielsen and Ms. Chandra argue that “valuations may have limited efficacy in predicting strategy returns” – strategy returns as opposed to asset returns. The authors highlight the “puzzling” case in which a defensive long/short strategy performed well during a recent two-year period when its value spread “normalized from abnormally rich levels.” They conclude that the relationship between valuation and performance – strong for most asset classes – is weaker for long/short factor portfolios. Wedging Mechanisms Buying a “rich” investment, seeing it cheapen, and yet still making money – how is this possible? Ilmanen et al. cite the following “wedge mechanisms” that allow the managers of long/short factor portfolios to loosen the “presumed strong link” between value spread changes and returns: Changing fundamentals Evolving positions Carry Beta mismatches Fundamentals May be Offsetting The efficacy of value spreads in predicting returns relies on the assumption that changes in valuations are primarily driven by prices, so that an asset or portfolio that becomes more expensive necessarily appreciates in price. This assumption, combined with the assumption that value spreads will always mean-revert, make the case that wide spreads are preferable to narrow ones. But valuation measures always compare price to a fundamental factor , and improving or deteriorating fundamentals – more than just price – can loosen the links between valuation and performance. Evolving Positions Portfolio returns are based on the price appreciation and “carry” of the portfolio’s holdings, as they evolve , but value spreads only consider the portfolio’s current holdings. Thus, the link between valuation and performance is therefore weakest for the most actively traded, fastest-evolving portfolios. Carry Returns Value spreads look entirely at prices, but portfolio returns are the sum of changes in price and portfolio income – i.e., dividends and interest. Portfolios that derive a greater-than-average percentage of their total returns from so-called “carry returns” will thus naturally have a weaker link between valuation and performance than portfolios that derive their returns more primarily through price changes alone. Misaligned Betas In AQR’s study, this final “wedge” had the most impact: Since the value spread will generally have a net non-zero beta, while a long/short portfolio may target beta-neutrality, the value spread could indicate cheapening or richening driven by its beta to the market, while a long/short portfolio designed for beta-neutrality won’t fluctuate with the market. Conclusion So are defensive stocks expensive right now? The authors give a concise answer to that question: “Yes, mildly, taking a 20-year perspective.” But as the “Tech Bubble” proved, mispricing can persist for a long time. The important thing, in the view of the paper’s authors, is for investors to be cognizant of the mechanics of value spreads and spread design choices.

From Overbought To Neutral: U.S. Index And Style ETFs

After two days of declines to start the week, just one of the U.S. equity index and style ETFs that we track in our daily ETF Trends report remains in overbought territory. One week ago, only one ETF was NOT overbought. You can see the “mean reversion” trade that has occurred in our trading range screen below. If you’ve never seen this screen from Bespoke before, please refer to the “Trading Range” description at the very bottom of this post. (click to enlarge)