A trifecta of needs has brought attention and flows to hedged equity investment strategies due to their resilient characteristics during volatile and uncertain periods. The unprecedented negative performance in both bonds and equities in 2022 has led investors and financial advisors to seek alternative investment strategies for income, to further diversify their portfolios, and more effectively manage risk.
Looking closer at the hedged equity marketplace, the Morningstar Options Trading and Derivative Income categories broadly encompass the space and have witnessed rapid growth. The assets in these two categories combined have grown from $12 billion in 2012 to $121 billion in 2023 (as of May 31), according to Morningstar data. This represents a compound annual growth rate of 24% over the last ten years, 37% over the past five years, and an impressive 56% over the last three years. The number of funds has also expanded rapidly, from just 19 in 2012 to 343 in 2022.
A recent research report entitled ”Exploring Hedged Equity Strategies” brings out important parameters to consider about these types of investment strategies. The report provides guidance on analyzing hedged equity strategies and outlines the key factors to consider such as choosing the right hedging method, active vs. passive management, sustainable yield, tax efficiency, transparency, and risk management.
We asked the authors of the report at Main Management – an independent, San Francisco-based advisory firm that was an early pioneer in managing all-ETF portfolios and utilizing option writing strategies – for further commentary on the key factors they determined as essential in running a hedged equity portfolio. Their experience in the asset class includes their covered call-writing Main BuyWrite ETF (ticker: BUYW) which had a positive performance return in 2022, pays out 50 bps per month in income, and was rated 4 stars by Morningstar in their Derivative Income category as of May 31st, 2023. Managing an ETF of ETFs portfolio that applies a covered call overlay strategy requires a dual skill set that can uncover subtle nuances that can have substantial impacts on long-term returns. With 20 years of experience managing ETF portfolios and utilizing covered call writing strategies, they offer insights to better understand this niche area of income and total return investing.
In my discussions with Main Management principals and Institute members - Kim Arthur and James Concidine, portfolio managers of BUYW, and Darol Ryan, Managing Partner – they detailed the following key factors managers and investors need to fully consider and how the decisions they made employing their decisions and strategy set themselves apart from the competition:
Choosing the Right Hedging Strategy - Selecting a strategy with the appropriate hedging method, such as either buying puts or selling calls, may significantly impact the performance and risk profile of a hedged equity strategy. Both approaches have their advantages and drawbacks. Buying puts may offer downside protection but requires precise market timing and can incur higher costs, while selling (writing) calls may generate consistent income to offset potential losses but may cap upside potential. It is important to select a hedging strategy that aligns with market conditions and clients' investment goals.
“In the Main BuyWrite strategy, we employ call-writing because we believe it offers a more consistent income stream, aligns with our expertise, and enables us to work on both parts of the portfolio synergistically. Financial advisors should understand the hedging method used by the strategy and how it fits within their clients' risk tolerance and investment objectives.” – James Concidine, Main Management
Active vs. Passive Management - Investors must also consider the trade-offs between active and passive management in both the equity allocation and options overlay within the strategy, as the methodology may significantly impact a strategy's performance. Typically, strategies choose to be active in either the equity allocation or options overlay, or even completely passive in both. Among a sample of the top 25 ETFs and top 25 mutual funds in the Morningstar Derivative Income and Options Trading categories, they identified merely five that boast an investment process that actively manages both the equities and the options overlay. In contrast, the remaining strategies either passively track an index on the equity side and/or adopt a completely systematic approach on the options side.
“We believe that active management is a critical component in a hedged equity strategy, particularly because of the many varied considerations within the strategy. Our active management style distinguishes itself with a harmonious, dual-active methodology encompassing both equity allocation and options hedging that has been running for nearly 20 years. This approach allows us to seize market opportunities and manage risk by concurrently evaluating the underlying equities and the options overlay. We are not trapped by systematic approaches. We can pick sectors of the market that are attractive with favorable options markets. We also have a managed process as to what option strike and maturity to select. ” – Kim Arthur, Main Management
Sustainable Yield vs. Self-Liquidating Funds - While high yields can be attractive, excessively high yields may potentially lead to strategies that are essentially “self-liquidating.” Often, these strategies may give up potential capital growth for unsustainably high income, leading to declining or stagnant capital over time. In other words, if the yield on a strategy seems too good to be true, that may well be the case. While some investors may be content with negligible or even negative capital growth in exchange for higher income, it's vital to recognize that unsustainable yield strategies cannot "have their cake and eat it too." Financial advisors and investors may want to consider whether they want to prioritize strategies that balance income generation and capital growth for long-term value.
“In studies that we have done which are illustrated in our report, a “self-liquidating” strategy experiences a decline in invested capital each year, essentially sacrificing capital growth for income. This growing divergence may be attributed to the power of compounding, where choosing higher distributions may hinder returns from compounding upon themselves. Opting for a strategy with unsustainably high yields may increase the likelihood of forfeiting potential capital growth, which could lead to long-term repercussions. We aim to achieve a sustainable yield which currently pays out 50bps a month that strikes a balance between income generation and capital growth, intending to deliver continued value to investors while fulfilling their income objectives.” – Darol Ryan, Main Management
Tax Efficiency - Income generation is not a one-size-fits-all approach, as various tax implications and considerations can arise depending on the management of a hedged equity strategy. Financial advisors may want to prioritize strategies that demonstrate tax awareness to ensure optimal outcomes for their clients.
“The Main BuyWrite ETF seeks to focus on tax awareness through its active management of both the equity allocation and options writing components, consistently monitoring tax implications with the objective of less returns lost to taxes compared to competitors in the Morningstar Derivative Income and Options Trading categories. Other hedged equity strategies, particularly passive ones, may inadvertently accumulate significant tax liabilities due to the nature of the income they distribute.” – Jim Concidine, Main Management
Transparency and Risk Management - Transparency and risk management are essential components of any investment strategy, as they enable financial advisors to make more informed decisions on behalf of their clients. Some hedged equity strategies can be opaque and use overly complex vehicles like swaps, making it difficult for investors to understand the underlying holdings and associated risks.
“We pride ourselves on the transparency of our ETF with clear daily disclosure of holdings and no use of complex derivatives like OTC equity swaps. Moreover, the strategy's simplicity of focusing on equity selection and covered calls written as an overlay allows for a more straightforward approach. Our management is a key differentiator – and not opaque derivatives – as we navigate the nuanced decisions on both parts of the portfolio. This transparency and simplicity enable investors and financial advisors to better assess the risks and potential rewards of the strategy and make better informed decisions.” – Kim Arthur, Main Management
Conclusion - Incorporating a hedged equity strategy in client portfolios may offer a unique value proposition providing something different and additive outside the traditional equity/fixed income portfolio while helping dampen portfolios against market volatility.
By considering factors such as hedging methods, active vs. passive management, sustainable yield, tax efficiency, transparency, and risk management, investors may make more informed decisions when allocating hedged equity strategies to their portfolios. They may want to consider whether to prioritize strategies that balance income generation and capital growth for long-term value.