XYLD - Searching For A Viable Covered Call ETF Alternative To XYLD

2023-10-01 08:28:02 ET

Summary

• The CBOE S&P 500 2% OTM BuyWrite Index is a covered call strategy that writes call options 2% out of the money.
• The BXY index has averaged an annual return of 9.91% since June 1988.
• There is no investable instrument that uses the BXY strategy, but the Invesco S&P 500 BuyWrite ETF is a promising alternative.

Introduction

I spent some time looking for covered call strategies that work and feel like I finally found one. The CBOE S&P 500 2% OTM Buywrite Index (BXY). CBOE describes the index as follows:

The CBOE S&P 500 2% OTM BuyWrite Index (BXY) is a benchmark index designed to track the performance of a hypothetical 2% out-of-the-money buy-write strategy on the S&P 500 Index. The BXY is a passive total return index based on (1) a “long” position indexed to the S&P 500 Index, and (2) "writing" (or selling) a near-term S&P 500 Index ( SPX ) "covered" call option, generally on the third Friday of each month.

This strategy is intriguing. Unlike many covered call option methodologies, it writes call options that are out of the money by 2%. For example, one might hold 100 shares of SPDR S&P 500 ETF Trust (SPY) at $445/share. They then write or sell a call option with a strike price of $455/share for $3.40/share with an expiration a month later. That is a premium one keeps; it generates an income in addition to the dividend SPY pays. If the ETF price does not reach $455, likely, the buyer of the contract will not exercise the option to buy the underlying security.

How does one lose money with this style of options contract?

1. If one owns 100 shares of SPY and the price drops, then they will incur the same losses as someone who did not sell an options contract. The benefit of selling the option contract is that one still earned the $3.40/share from the written option contract, thus limiting their overall losses.
2. One can see profits if the price rises to the strike price. For example, if the price rises to $450 per share, they see an unrealized profit of $5/share and still have the $3.40/share from selling the contract. That is a return of 1.89% with the option contract providing 40% of that return.
3. If the price rises about $455/share and up to $458.40/share and someone exercises the option to buy, they must sell their 100 shares and keep the premium from the contract. For example, if the price reaches $458/share, they might be forced to sell at $455/share but keep the $3.40/share for the option sale. That still results in a 3.01% profit.
4. This is where one will lose money on selling covered call contracts. If the price rises above $458.40/share, and the option is exercised, and it will be, the owner of the 100 shares will have to sell their holdings for $455/share. For example, if the price rises to $460/share, the contract owner will force a sale for $450/share. They will net the difference between $460/share and $458.40/share. In the meantime, the seller of the contract will net a profit of $10/share ($455-$445) plus the $3.40/share for selling the contract. In all, the seller of the contract nets a profit of 3.01%. If they had not sold the contract, they would have netted a realized gain of 3.37%.

Past Performance

Fortunately, Morningstar has provided us with information about this strategy, and its theoretical performance. From 1989 to 2022, the BXY index has averaged an annual return of 9.54%. This compares quite favorably against the S&P 500 at 10.34%. Here are a few numbers with risk factors from those years. I focused on 1989-2022 for consistency in the calculations and for comparisons to other strategies.

One can see that this strategy does provide someone with some risk protection when the markets go haywire. It outperforms during down markets, reduces volatility by 20%, and has better risk metrics.

Great, Let’s Buy a Fund That Does This

I firmly believe in alternative investing, including gold, real estate, and hedging strategies. Hedging strategies should take up no more than 15% of one’s portfolio, so I am not talking about any large holdings. Curiously, there is no investable instrument that uses this strategy. At one time, Global X S&P 500® Covered Call ETF (XYLD) did use it, but on August 20, 2020, it changed its investment methodology. Since 2020, XYLD has been using the CBOE S&P 500 BuyWrite Index (BXM) as its investment criteria. Was this a mistake to change philosophies? Here is some data to find out.

As one can see, the overall return shows that BXY is far better (9.54% v. 8.19%). There is a case, however, that BXM has better risk metrics, with lower volatility (12.53% v. 15.03%) and better performance during down markets (-8.11% v. -10.91%). Regardless, I like the superior return of BXY.

Since it is important to view a hedging strategy within an allocated portfolio, I decided to see how this might function as a part of one’s overall investment philosophy.

Should BXY Be Part of An Overall Portfolio?

The illustrations shown so far assume an all-or-nothing approach to an investment portfolio. Of course, one should look at a well-balanced approach with investments across different asset classes. As an illustration, I wanted to compare two separate portfolios, one with BXY as part of the portfolio, and one without. I used my risk tolerance profile to do this experiment. Here are the asset distributions for each.

Here is the data comparing the two portfolios:

Based on these numbers, a well-balanced portfolio with BXY compares favorably with a portfolio that does not use a hedging strategy. While a non-hedge portfolio does yield a better return (9.54% v. 9.43%), the hedged portfolio produces better risk metrics for a slightly less risky strategy. Note: I cannot access Sharpe or Sortino ratios since I cannot calculate month-to-month data.

My Take

First, in my opinion, it was a mistake for Global X Funds to change the methodology of XYLD. Either Global X needs to bring it back, or someone else does. Because of that, a viable option strategy is not available to the mainstream investor without that investor writing their own call options. Second, if one wants to use a strategy like BXY, it does show promise in terms of limiting risk if it is part of a well-balanced allocation strategy.

If one wants to explore ETFs that approach this kind of strategy, I suggest looking at Invesco S&P 500 BuyWrite ETF (PBP). Invesco writes in its prospectus for PBP that it does write some covered calls that are above the prevailing price level. This might be promising for those looking for this strategy because it has outperformed XYLD (7.74% v. 7.42%) since the beginning of September 2020 in terms of total annual return. Morningstar gives it a 3-star rating. It yields a 1.20% distribution, which might not work for an income-oriented investor.

I wish I had better solutions. It is frustrating to see a strategy that works so easily dismissed by the industry. Investors deserve better.

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