KWEB - KLIP: High Income And Cheap Valuations Suggest Strong Returns

2024-01-17 20:10:15 ET

Summary

• The Kraneshares China Internet And Covered Call Strategy ETF has outperformed the KraneShares CSI China Internet ETF by 45% in its first year, thanks to option income.
• KLIP follows a covered call strategy, which has generated 68% annualized income returns since inception by selling slightly out-of-the-money call options on KWEB.
• With Chinese tech stocks looking undervalued and under-owned, a contrarian rally should allow the KLIP to generate outsized returns.

The Kraneshares China Internet And Covered Call Strategy ETF ( KLIP ) has only been around for one year, but over this time its performance has been impressive, gaining 5% and outperforming the KraneShares CSI China Internet ETF ( KWEB ) by a staggering 45% thanks to option income. With a staggering 64% dividend yield it would take a further sustained crash in Chinese tech stocks for the KLIP to decline, which seems unlikely given how far they have already declined. The KLIP is ideal for investors looking for Chinese tech exposure with high income.

The KLIP ETF

The KLIP seeks to provide income by following a covered call or buy-write strategy which involves buying shares of the KWEB and selling corresponding call options on it. The fund sells monthly call options that are slightly out of the money, which have generated 68% annualised income returns since its inception.

Both KLIP and KWEB are benchmarked to the CSI Overseas China Internet Index, which tracks the performance of the investable universe of publicly traded China-based companies in the Internet sector. Tencent (TCEHY) and Alibaba (BABA) are the two main stocks in the KWEB, each having a 9% weighting, and their fall from their bubble peaks in 2020 and 2021 has been a major drag on the index, which has fallen 75% from its peak. Over the past year alone the KLIP's KWEB holdings have fallen by 28%, but the fund has managed to generate positive returns thanks to option income, which has more than offset capital losses.

Like all buywrite funds, the KLIP will perform best if the underlying market rises but is likely to underperform the KWEB itself if there is a strong rally as it would not enjoy as much capital gains. Conversely, the worst-case scenario for the KLIP would be a market crash as it is exposed to downside losses, but it would outperform the KWEB due to option income. The KLIP is therefore suited for investors looking for Chinese tech exposure and willing to sacrifice capital gains for substantial monthly income.

The following chart shows the performance of the KLIP's price (white line), the KWEB (orange line), and the KLIP in total return terms (yellow line). The KLIP's price has underperformed the KWEB, which is inevitable as it fails to benefit from significant KWEB rallies due to its call option sales (as seen in June-July), while still falling during KWEB declines. When option income is included, however, the KLIP's total return performance has been a respectable 5%.

Depressed China Tech Valuation Suggests Deep Losses Unlikely

After a huge decline in Chinese tech valuations, the potential for further large declines has fallen, and even a sideways market would allow the KLIP to generate huge returns. Alibaba now trades at a single-digit PE ratio of 9x, down from a peak of 58x in 2020, while Tencent trades at 13x, down from 42x. Tencent now offers a free cash flow yield of 14%, which is staggeringly high for a growth stock. Furthermore, sentiment towards China is deeply bearish, as this chart from Bloomberg shows, with both mutual fund and hedge fund exposure to the market near cycle lows. This creates the conditions for a strong rebound in the KWEB.

The main drawbacks to the KLIP come from its high expense ratio of 0.95% and its limited track record. There is also the risk of underperforming the KWEB in the event of a strong contrarian rally in Chinese tech stocks, particularly as implied volatility has come down in recent months which should reduce KLIP's option income. However, it is difficult to see the KLIP losing money in total return terms with Chinese tech stocks undervalued and option income likely to remain strong.

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