Small-cap stocks usually aren’t associated with robust levels of income. They are, however, known for being more volatile than larger counterparts.
That’s simply the price of admission for accessing the growth offered by smaller stocks, but in market climates such as the current one when growth stocks are out of favor, the growth profile offered by small-caps isn’t a selling point to clients. It’s more of a warning sign.
In other words, advisors probably have some work ahead of them when it comes to discussing small-caps with clients, but this asset class currently offers more benefits than many clients are aware of. Today, it’s a matter of methodology. A potentially compelling mousetrap for small-cap exposure in this environment is by way of covered call funds.
As advisors know, covered call strategies are often rewarding in turbulent market settings because options premium move higher, meaning more income to options writers or sellers.
“BlackRock believes that by using an equity covered call strategy, investors can reduce portfolio volatility by capturing option premiums, without having to sacrifice long-term performance,” according to BlackRock research. “In a covered call strategy, investors sell call options against their equity holdings and receive an upfront “option premium” in exchange for forgoing potential capital appreciation if the underlying stock appreciates above the option strike price. These option premiums generate cash flow which help to mitigate some of the downside risk to owning the stock.”
There are a variety of covered call exchange traded funds on the market today and the Global X Russell 2000 Covered Call ETF is one to consider for small-cap exposure.
As its name implies, RYLD is linked to the Russell 2000 Index, which is one of the most widely observed gauges of small-cap stocks in the world. Amid rising interest rates and economic uncertainty, Russell 2000 exposure with income protection could be worth examining.
“The Russell 2000 has produced higher levels of volatility compared to the Nasdaq 100 and S&P 500. As the future US economic data becomes more uncertain amid lower earnings growth, higher inflation, and unexpected geopolitical tension arising, a strategy like employing covered calls on the Russell 2000 can offer a buffer from the premiums collected during these periods,” according to Global X research.
The benefit of a strategy such as RYLD is twofold. First, end users – advisors and clients – don’t have to endure the legwork of options writing on the Russell 2000. RYLD does it for them. Second, the fund allows clients to own a long position in an underlying asset while generating far more income on it than on a standalone, non-options basis. Additionally, history shows a fund like RYLD could benefit clients as rates continue rising.
“The futures market is currently pricing a shift in monetary policy, shown by the Fed futures market betting on the Fed cutting rates in early 2023. While a long-term shift in policy could produce increased revenue for cyclical and sensitive sectors within the Russell 2000, in the short-term, historically small cap risk premiums traditionally accelerate as the cost of borrowing for small caps increases compared to larger companies,” adds Global X.
RYLD, Not Perfect, But Good Outweighs Bad
As is always the case in financial markets, there’s no free lunch with covered call strategies. The rub with a fund such as RYLD is that will not capture all of the Russell 2000’s upside when stocks are rising. Conversely, RYLD always sports lower annualized volatility and outperforms the non-options index when markets slump.
Plus, there’s the income proposition. RYLD sports a distribution yield of 12%.
“In addition, the income from value-based covered call strategies can help diversify an income portfolio away from traditional sources like dividend paying stocks or fixed income. A Russell 2000 covered call strategy may be an alternative way for investors to generate potential income and remain invested in the equity market,” concludes Global X.