There has been a great deal of attention directed over the last couple of years towards a strategy known as “buy/write”. This post will look at how such a strategy has worked, and how the current market impacts such a process.
The reason for this post is the strong market focus by advertisers and promoters of various strategies that claim that a “buy and hold” strategy is no longer appropriate, and that a more volatile world means the average person should adopt a far more active process with their money. To me, these suggestions of large swings in strategy are the equivalent of trying to best place windmills to catch fickle winds but i’m not completely against such ideas. It’s more a case of disliking marketing strategies that seek to apply sophisticated or niche solutions to mainstream markets. I’ve seen it done many times over the years, and it usually ends in tears.
There are many ways of being “more active”, so we will look at a few over time. The buy/write strategy is a good starting point for considering just how some of these more active processes work, and whether the extra effort is justified in actual results.
What is “buy/write”?
Simply put, it is the process whereby an investor holding a parcel of shares decides to sell the right for someone else to buy those shares at a given price. That earns them a “premium”, which is extra income from the share holdings. For example, you may write an option where you promise to sell those shares if the price lifts by (say) 8%. If the shares do not lift that much then the option will expire worthless, and you get to keep your shares and the premium that was paid for the option. If the shareprice lifts above the 8% level then the holder of the option will buy those shares off you for that price. You therefore get the premium, any dividends you may have earned along the way, and a profit when the shares are sold.
Here is a link to the ASX brochure on the strategy.
As you may have noticed, this is a ‘trading’ strategy, which may or may not improve your overall returns. However, in the last couple of years we have had a sharemarket that has not really moved very far – perfect conditions in which to write options for a bit of extra income.
A look at the recent past…
An individual can set out to follow the buy/write process themselves or they can pay an institutional fund manager to do it for them. One such fund is the Zurich Equity Income Fund. It basically holds a Top 50 portfolio, and seeks to buy and sell options on that portfolio to obtain a higher regular income. The ability of the fund to achieve this mandate is quite impressive, with a strong regular monthly income being paid to unit-holders.
For the technically minded, i have chosen not to use the available market index (ASX code: XBW) owing to the difficulty of actually implementing a full buy/write strategy over rolling time periods. i have instead chosen to illustrate the results that have actually been acheived by an active fund manager, who is well funded and has access to the scale and expertise required to obtain results. This is not a recommendation of this particular fund over any other – you will need to seek personal advice before anyone could even comment on the suitability of this fund for you. It is simply choosing an actual fund over a difficult-to-replicate index.
If we chart the fund unit price (which ignores dividends) against an index of the Top 50 shares on the Australian Stock Exchange then we can see how the process has panned out.
You can see that the returns are similar. As would be expected, the bare index of the top 50 companies on the ASX would most likely have resulted in a higher capital return over the period. This is to be expected, as the person operating a buy/write strategy has received a signficantly higher income over the period (in very rough terms, an income of 10% over teh 12 months versus around 5.4% for the XFL index.
The end result of a buy/write strategy versus a buy-and-hold?
If you simply bought the top 50 index then you would be down 14.6% in capital today from where you were a year ago. You would have earned 5.4% income which would mean your net position is around minus 9.2%.
If you were actively using a buy/write strategy, you would be down around 15.1% in capital but you would have earned something close to 10% in income, which would mean your net position is around minus 5.1%.
The difference between the two strategies is 4.1%, in favour of the buy/write strategy.
Keep in mind that the Zurich fund includes the trading cost of the fund manager, as well as the cost of issuing taxation statements and records. While a proponent of active trading would suggest that you could ‘do better’ by more clever stock selection – and therefore reduce your capital loss, it is likely that your costs for operating such a portfolio and the associated accounting/paperwork expenses, would negate all but the most extreme individual selection benefit.
But wait! i hear you call. This is just Michael exhibiting a bias against an active trading strategy. Just another financial planner trying to justify a failed buy-and-hold strategy! Even if the costs add up to 2% in a full year, that is still a full 2.1% better than a buy and hold strategy. That is outperformance, and no-one should sneeze at outright outperformance.
Don’t worry, i’ve been told such things before. And yes, outperformance is a good thing in nearly all circumstances. However, my daily financial planner activities assure me that no client sitting down to review a portfolio is going to be happy that their overall performance of MINUS 5.1% is better than others by a few percent or so. Regardless of “risk profiles” or our individual “tolerance for risk”, all investors want to see a positive return from their efforts and the risks that they take. Moving from a buy-and-hold strategy to an active trading strategy will suit some investors, and should always be at least considered by those who are fluent in financial markets, and those who have the time and expertise (or access to that expertise through an efficient stockbroker) to carry through on their objectives.
As for bias… yes, i have a bias towards a less active strategy (aside from portfolio rebalancing), owing to my experiences of watching many people embark down an active pathway. My anecdotal market sample points to most people making that change during ‘lulls’ in share or property markets. The active trading results in greater selection risks being taken, as well as timing risks. Even when it works, the end result is often a tendency to see all positive results as a reflection of ability or skill, rather than an incidental mix of strategy with market timing. In my experience there number of active investors who track their performance against a robust market benchmark is somewhere close to nil. A bit like the regular gambler at the racetrack, who would suggest that on average they are “a little ahead or a little behind”.
The very important point here is purpose. If your purpose was to obtain a higher regular income, and you are able to cope with “standard” volatility of your capital then the buy/write strategy at this time would have suited your purposes admirably. If you were simply looking for better total performance then you are unlikely to be all that happy with the end result. You would still have been better off leaving your money in cash.
Active or not?
All experienced financial market participants will have very strong views as to whether it is better to adopt an active strategy or a buy-and-hold strategy. This means that there is no ‘correct’ answer, other than that which best suits the individual.
Simply put, some people would rather “do something than do nothing”. These people would see it as simple foolishness to retain a buy-and-hold strategy in the face of 5 years of nil returns – 10 years if we are looking at international investments. If that is you then it is likely that you have already acted – maybe withdrawing funds from a managed investment or started your own self-managed super fund or simply sold down your investments to move to cash. If that is you then it is also likely that you have at least considered the idea of building a portfolio of investments and then earning extra income through an options strategy.
The key message from this post that i would ask you to take away and ponder over a cup of your favourite beverage is to think carefully before embarking down an active strategy. Make sure you set up a firm benchmark so that you can honestly say whether you have done better or worse than the overall market you are operating in. And include all costs and charges associated with that strategy – including extra costs and time to prepare and submit your tax return. At this point in a market cycle, it is “standard” to look to a change for change sake, so i’m not going to stop anyone from embarking down that pathway. Just do it with your eyes open, and make sure you take the time to review your approach so you are ready to change your strategy again when the market cycle changes.
Remember the Great Disclaimer – none of this post is to be taken as personal advice, which can only be provided after appropriate review of your total personal financial position, objectives and risk tolerance. This is general advice only, and pretty average stuff at that – any broad statement on markets/sectors or products will overplay or understate areas that could be very important, so please remember to always read the full documentation associated with anything that you do!