Investment Strategy

The devil is in the detail (more on strategies to avoid)

OfWealth has been taking a look at how the ever-inventive financial industry comes up with fancy and expensive new ideas all the time. Last week I wrote about the problems with strategies that involve selling options. The major drawback is simply the huge amount of time-consuming trading that’s involved, let alone that they probably don’t work in terms of making the claimed extra profits. But assuming that they do work, what if someone offered a way to follow this kind of strategy, but without all the work? Sounds great, right? Wrong.

Hitching a ride on back of the fashion for option strategies, there is an ETF that follows a covered call strategy on the stocks included within the S&P 500 index of large US stocks.

It’s called the Horizons S&P 500 Covered Call ETF (NYSE:HSPX). Currently it controls investments worth US$71 million, which isn’t exactly huge, but neither is it too small to be unsustainable.

The idea is to own stocks in the S&P 500 index and “write” (sell) call options on those stocks. The options are “out of the money”, meaning the price at which the option buyers can purchase the shares from HSPX is slightly above the market price of those shares at the time the option is written. The options last for one month before being renewed, and in September 90% were unexercised – which means 10% were exercised.

Typically the strike price is around 4-6% above the market price. This means each share price has to rise that much before the owners of the call options buy the shares. But any price rises above that amount are lost by investors in the fund, which is forced to sell the shares at that point. (See here for more on how call options work.)

Little work for the investor, but supposedly better returns under most market conditions.

So far so good. The ETF has the promise of providing the enhanced income of a covered call strategy, but without the hassle of having to make all the hundreds of option and stock trades each year yourself. That gets handled by the fund manager. Little work for the investor, but supposedly better returns under most market conditions.

In income terms it appears to do exactly what is claimed. The dividend yield of the underlying S&P 500 index is 2.05%. The income yield of HSPX is 5.95%, or almost three times as much.

But where this fund falls down massively is on the capital gains. All covered call strategies give up capital gains. However this particular fund gives up even more than usual, as I’ll explain.

HSPX was launched in June 2013, so has almost two and a half years of track record to assess. Fund literature claims that the strategy will outperform the S&P 500 index during down, sideways, or modestly rising markets. At the same time it’s expected to underperform the S&P 500 index in a strong bull market.

The theory…



This makes sense at first glance. But, as always, the devil is in the detail. So far the fund has significantly underperformed the S&P 500 index in both rising and sideways markets, as shown in the following chart. There are good reasons for this.

…doesn’t match the reality.


According to the chart, between 21 June 2013 and 30 September 2015 HSPX returned around 13%, including all income from dividends and call options sold, plus capital gains. In the meantime the total return on the underlying S&P 500 index was 24%, including dividends and capital gains. In other words the covered call ETF has underperformed the index by 11% over two and a quarter years (and nine days).

So why doesn’t this attractive sounding, zero hassle, income strategy actually work in practice? Why is performance worse than a simple buy-and-hold strategy on the underlying index? Remember, the income yield has practically tripled, which means that capital gains must have been vaporised somehow.

Admittedly the fund literature says the strategy is expected to underperform in a strong bull market. That’s because if prices of individual stocks rise fast then a lot of the the call options will be exercised by their owners. In turn that means the fund has to sell underlying shares at the option strike prices and give up part of the capital gains that otherwise would have accrued at market price.

Between June 2013 and November 2014 the S&P 500 index was in a strong rising trend, so perhaps it’s no surprise that HSPX underperformed the index over that time.

But more recently the S&P 500 has moved sideways, and yet HSPX has continued to underperform. In the year to September 2015 the total return, including dividends, of the S&P 500 was minus 0.6%. But HSPX lost 3.9%, which is to say it was down 3.3% more than the index. Clearly it’s not living up to its promise of overperforming in sideways markets.

One culprit could be fees. But these are only 0.65% a year, which still leaves 2.6% of the past year’s underperformance unexplained.

The problem lies in the structure of the fund. Remember this is an index tracker with a twist. The fund has to own all the stocks in the index, with options written on all the stocks possible (currently 82% of the index).

This creates a massive flaw in the strategy. If an individual stock’s price rises above the strike price of the call option that has been sold on it, then the owner of the option will exercise it, buying the stock at below the current market price.

But because HSPX has to own all the stocks in the index – since it’s a tracker – it then has to buy the sold stocks again at a higher price. In other words the structure ensures that the ETF is regularly selling some stocks at one price and then buying them again more expensively. That’s a sure recipe for poor returns.

HSPX is a great example of a product that promises more than it can ever possibly deliver. It takes the hassle out of investing in a covered call strategy, but at the same time it’s almost bound to underperform a simple buy and hold investment in the index.

Investors get much higher income than just owning the index, but at the expense of surrendering huge capital gains. There is no logic to anyone wanting that outcome.

The only scenario where HSPX can outperform is if most of the underlying stock prices are falling, which would mean that none or very few of the call options are ever exercised.

…if you think that’s going to happen, then why own the index in the first place?

But if you think that’s going to happen, then why own the index in the first place? In any case, it will go on to underperform again if and when the market starts rising once more after a big fall. Over the long run returns look sure to be poor.

There are no shortcuts in investing. As I explained in the previous article, do-it-yourself covered call strategies – where you select individual stocks and sell call options on them – are a huge amount of work. They’re also unlikely to outperform a simple buy-and-hold strategy in cheaply priced value stocks. This is because any extra income from selling call options is likely to be outweighed – and some – by the forfeited capital gains.

In the meantime, covered call strategies that track an index, like HSPX, are deeply flawed for the reasons explained previously. It’s just possible that an active fund manager, as opposed to a tracker fund, could offer a successful covered call fund – with carefully selected, but non-indexed investments. But the fees would probably be high in any case, negating the supposed benefits.

In common with many products offered by the financial services industry, HSPX is just another example of something that sounds great at first glance. But, when you get down to it, the structure is flawed and a recipe for poor performance.

Whether it’s a hedge fund, structured product, option strategy, or any other complex and sophisticated fee machine invented by the financial services industry, it’s unlikely to work out well for the investor.

As always, our recommendation is to keep it simple. You’ll find our five things that every investor must do here, and our 50 different ways to invest (including a handy infographic) here. Buy low – when and where you can find bargains – and hold for the medium to long term.

Stay tuned OfWealthers,

Rob Marstrand

Previous ArticleNext Article
Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.