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XYLG Generated Strong Yield, But the Price Performance is Erratic
Global X S&P 500 Covered Call & Growth ETF (NYSEARCA:XYLG) is an exchange-traded fund (“ETF”) that invests in equities and is engaged in selling call options. The fund invests in stocks and options of companies primarily operating in the technology, financial, and healthcare sectors. Together, these three sectors account for almost 55 percent of its total investments. It mainly invests in growth and value stocks of large-cap companies. The fund seeks to track the performance of the CBOE S&P 500 Half BuyWrite Index by using full replication techniques.
The fund generates a yield in excess of 6 percent. With a monthly pay-out, this yield is quite high under the current market condition. But the ETF’s price growth has not been impressive. Prices dropped by almost 14 percent during this year. Prior to that, the stock generated substantial capital gain. Since its inception in September 2020, the fund gained almost 27 percent in the first 15 months of its operation. The relatively strong yield has resulted in a strong total return over the years.
How Does Covered Call Strategy Work?
A call option is a contract that gives the buyer the right, but not the obligation, to buy a stock at an agreed upon price within a certain period or on a specific date. A covered call option thus involves holding a long position in common equities, and writing a call option on the same equity shares. The sole objective of this strategy is to gain the option premiums, expecting that the option buyer will not exercise the option.
However, by using covered call options, an investor limits his/her opportunity to profit from an increase in the price of the underlying stock. However, there is huge risk in case the stock loses its value. In such a case, the option buyer exercises his option, and the option seller may have to forgo a huge amount which may be much more than the gain he/she made from the option premium. Thus, a covered call option, though it generates a good income upfront, comes with huge risk related to capital gains.
Covered Call Strategy Works Best During Uncertain Market Conditions
Covered call strategies may be useful during uncertain market conditions, i.e., in a trendless/flat market. As volatility tends to remain high, option buyers are generally willing to pay more premium. So, the option seller can earn higher income through selling call options. XYLG sells call options on 50 percent of its holdings. As the fund was launched during the covid-19 pandemic, the fund made significant gains in its initial months, due to higher premiums in call options. That is not the case during the current calendar year, i.e., 2022.
In times of high volatility, the option premiums tend to be extremely high. The buyer of the option will only exercise the option when it is favorable. Higher volatility means higher upside or downside risk. When there is downside risk, the buyer of the call option will forego the premium. When there is upside potential, the buyer of the call option will make significant profits. That’s why option premiums are high when the market is uncertain.
Risks Involved in XYLG’s Covered Call Strategy
When a fund sells call options on 50 percent of its holdings, technically it foregoes the upside potential on 50 percent of its portfolio. So, in a bullish market, a fund like XYLG will fail to perform better than other index funds. In a bearish market, the fund will lose on its equity part that is not covered through selling call options. Thus the fund always faces uncertainty in terms of capital gains. However, the premium received on sale of call options are pure gains to XYLG. In a volatile market, these premiums become higher than usual, and thus enable the fund to generate higher yield.
Thus, investors can expect a strong yield from this fund. However, the capital gains will be highly uncertain. The price gain in the fund’s initial 15 months should not be taken as a benchmark due to the short time span as well as the impact of covid-19. The return during that period is highly unlikely to be repeated over a longer period of time. In the long run the capital gains will most likely be low, as neither the bullish nor the bearish market helps this fund.
The Composition of Portfolio Still Matters
It may seem that the option premium is the primary factor for consideration, and an uncertain market is the only time to buy this fund. However, like any other derivative product, the underlying stocks are still the primary factors that need to be considered by investors. In the case of XYLG, stocks from technology, financial, and healthcare sectors constitute almost 55 percent of the entire portfolio. So, a lot will depend upon how these three sectors perform in the coming months.
The portfolio is composed of all the big names from these three sectors, such as – Apple Inc. (AAPL), Microsoft Corp (MSFT), Amazon.com, Inc (AMZN), Alphabet Inc. (GOOG, GOOGL), Tesla, Inc. (TSLA), Berkshire Hathaway Inc. (BRK.A, BRK.B), UnitedHealth Group Incorporated (UNH), Johnson & Johnson (JNJ), etc. As these stocks are highly traded, they are likely to be more volatile. Top 10 holdings of XYLG constitute almost 30 percent of the entire portfolio. From that viewpoint, investing in these stocks creates a higher scope of generating strong yield.
Investment Thesis
Global X S&P 500 Covered Call & Growth ETF pays a monthly dividend with a strong yield. The trailing twelve month (TTM) yield of 8 percent surely is quite attractive to the income-seeking investors. The fund is able to generate such strong yield on the basis of premium gained from writing call options on 50 percent of its portfolio. Thus, the yield is expected to continue unless the market enters into sustained bullish or bearish trends over a longer time horizon. At present, either a long term bullish or bearish phase is quite unlikely. Thus, there is a decent possibility of enjoying strong dividend yield over the coming months.
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