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Covered call writing is a defensive, low(er) beta, strategy. When the markets rise, you get a nice return. That return will probably be lower than the return of the equity markets itself, but that’s something you know in advance.
When the equity markets fall, you should outperform thanks to the collected option premiums. Of course, when the market really tanks, you will still have a negative return. That’s why we prefer not to invest in such a strategy when the equity market is in a long term down trend. It’s only recently that this is no longer the case. So we think finally all lights are green to buy the Amplify CWP Enhanced Dividend Income ETF (NYSEARCA:DIVO).
Covered calls
Covered call writing is a conservative strategy with only two possible outcomes. If the stock is sold at a higher price on the expiration date of the call option, the call writer keeps the option premium and also the appreciation of the underlying stock up to the strike price.
On the other hand, if the stock never exceeds the strike price during the period up to expiration, the call writer keeps the option premium and also keeps the stock in the portfolio. A negative total return cannot be excluded in this case.
In both cases, the collected option premium is a source of income.
Over the past 12 months, the S&P 500 was down almost 13%.
Figure 1: Total Return Chart (Yahoo! Finance, Author)
When the stock market falls more than 10%, you would expect a covered call ETF to outperform. Both DIVO and the Global X S&P 500 Covered Call (XYLD) generally do.
When the stock market falls more than 10%, you would expect a covered call ETF to have a negative return. XYLD did, but DIVO didn’t! DIVO posted a positive return over the past 12 months! This nice performance isn’t limited to the past 12 months.
When we take a look over a longer period, we do see indeed that covered call ETFs underperform when the stock market is rising. But while the stock market is up in the period from the depths of the covid-crisis until now, DIVO is outperforming the S&P 500 over that period.
Figure 2: Total Return Chart (Yahoo! Finance, Author)
What’s the difference between XYLD and DIVO? Active management.
Active management
XYLD uses a more systematic approach: it buys the complete S&P 500 and writes calls every month on the index.
DIVO is more actively managed, both concerning the stock selection and the call writing strategy. DIVO buys 20 to 25 high-quality large-caps with a history of dividend growth, along with a tactical covered call strategy on individual stocks.
Figure 3: Portfolio construction (Amplify ETFs)
Based on market observations and income targets, the portfolio managers use a rules-based set of triggers to identify the best covered call opportunities on the stocks in their portfolio.
They look for opportunities to write covered calls when the VIX is at 15 or higher. And the higher the implied volatility, the higher the premiums you can collect when writing options. DIVO aims for call premiums that will yield them 2 to 4% on an annual basis.
Figure 4: Sources of return (Amplify ETFs)
The VIX is currently at 19, allowing DIVO to write calls at attractive premiums.
The second pillar of DIVO’s active management concerns stock selection. DIVO buys 20 to 25 high-quality large-caps with a history of dividend growth.
Figure 5: Top 10 holdings (Amplify ETFs)
The biggest sectors in the portfolio are Energy and Healthcare.
Figure 6: Sector allocation (Amplify ETFs)
Compared to the S&P 500 the biggest overweights are Energy, Healthcare and Consumer Staples.
Figure 7: Sector drift (ETF Research Center)
Those three sectors are also the only sectors in a clear long term uptrend.
Figure 8: Trends (Yahoo! Finance, Author)
The biggest underweights are Technology, Communication Services and Real Estate. We can only conclude that we like DIVO’s stock selection.
The last light flashes green
DIVO’s active management, both on stock selection and call writing strategy, resulted in a very nice performance. All lights are green on this level.
When the equity market really goes down, a covered call strategy can’t shield you from a negative return. That’s why we prefer not to invest in such a strategy when the equity market is in a long term down trend. It’s only recently that this is no longer the case.
Figure 9: Total Return Chart (Yahoo! Finance, Author)
When the LT trend is clearly up, we get a green light/color. Vice versa, when the LT trend is clearly down, we see a red light/color. In between the color is orange.
The ribbon in the price-part of the chart shows the LT trend-color, while the lower part of the chart shows the ST trend. We left out the orange coloring to avoid overloading the chart.
The last light also flashes green!
Figure 10: Total Return Chart (Yahoo! Finance, Author)
DIVO has a (reasonable) expense ratio of 0.55% and a dividend yield of 4.7%.
Conclusion
When the stock market falls more than 10%, you would expect a covered call ETF to outperform the market on the one hand, but also to have a negative return on the other hand. This is the case e.g. for XYLD. This is however not the case for DIVO. In these circumstances it managed to post a positive total return over the past 12 months! This is thanks to its excellent stock selection and call writing strategy.
Only recently the S&P 500 is no longer in a long term downtrend. For us, there is no longer any reason not to invest in the Amplify CWP Enhanced Dividend Income ETF. Buy!
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