This article is part of a series of regular pieces where we will discuss recently issued exchange-traded products (ETPs) which are seen to be innovative or otherwise attempt to improve upon existing strategies available within an ETP wrapper. Our intention is to give the reader a better understanding of those products and highlight potential benefits and risks for investors. Last time, we examined the monthly leveraged ETFs from RBS.
Lyxor ETF EURO STOXX 50 BuyWrite
In this article, we will discuss the Lyxor ETF EURO STOXX 50 BuyWrite. Even though this ETF was launched quite a while ago (January 2007), we think this product could be an interesting investment in the current uncertain, and very volatile market environment.
The ETF tracks the EURO STOXX 50 BuyWrite Index. Essentially, the index consists of a long position in the EURO STOXX 50 Index and the simultaneous sale of an out-of-the-money call option on the index, a so-called covered call. The covered call effectively caps the potential upside on the index’s return and at the same time generates additional income through the premium received from selling the call. Investors wanting to cover the basics of options before delving any further into the details of this strategy are advised to read our Morningstar Guide to Equity Option Investing. This guide also introduces readers to fundamentally sound option investing strategies that could generate solid investment performance over the long run.
Is Selling Covered Calls a Good Investment Strategy?
Why would anyone buy this ETF instead of (or in addition to) one tracking the plain vanilla EURO STOXX 50 Index? To answer this question, let’s examine the potential pay-offs of the covered call strategy employed by this ETF’s benchmark.
In the hypothetical example above, we can see that as long as the index remains below a level of 3890 (3.7% above spot), the EURO STOXX 50 BuyWrite Index outperforms the plain-vanilla EURO STOXX 50 Index. Once the EURO STOXX 50 exceeds 3890 (the strike price on the call options that the buy-write index has sold), the plain vanilla index will begin to outperform the buy-write index. As can be seen above, the buy-write strategy also offers some downside protection relative to a pure long position in the EURO STOXX 50. This buffer comes from the premiums received from selling call options. Given its limited upside potential and downside protection, this strategy will perform best in sideways trending markets.
Now, let’s look at the index’s historical performance. The following graph shows the monthly return for the EURO STOXX 50 Index versus the hypothetical return for the EURO STOXX 50 BuyWrite Index since March 1987 and the three year monthly rolling volatility for the EURO STOXX 50 Index. For the EURO STOXX 50 BuyWrite Index, we assumed a strike price at spot plus 4% and an option premium of 1% of the spot index value in each month.
Given our assumptions, the EURO STOXX 50 BuyWrite Index would have generated annualised returns of 9.0% over this period. By way of comparison, the EURO STOXX 50 Index returned 7.3% on an annualised basis over the same period. Furthermore, the EURO STOXX 50 BuyWrite Index outperformed the EURO STOXX 50 Index in 232 out of the 293 months during this time period.
But more importantly, let’s have a look on how the EURO STOXX 50 BuyWrite Index performed across various market cycles.
As we can see, the option strategy was not the superior strategy in all market environments. In fact, the lion’s share of the buy write strategy’s outperformance came in the years between 2003 and 2008. The reason for this outperformance is the fact that through this period, the EURO STOXX 50 Index rarely saw monthly returns in excess of 4% (the assumed strike price above spot). Therefore, the strategy participated in nearly all of the monthly upside of the performance of the EURO STOXX 50 over this span in addition to earning the assumed 1% option premium. As seen in the table above, compounding this over almost 5 years resulted in substantial outperformance for the buy-write strategy.
Looking at the actual returns for the Lyxor ETF EURO STOXX 50 BuyWrite since inception, we can see that the ETF has consistently outperformed during market downturns—with the option premiums serving as a downside buffer. Meanwhile the strategy’s underperformance in the 2009 rebound can be attributed to the fact that the option strategy capped its upside.
We’d add one note of caution regarding our hypothetical index calculation. For purposes of simplicity we assumed a constant option premium (1% of spot) which in reality is obviously not the case. As highlighted in our guide on options, many variables will influence the price for options and hence the returns for the covered call strategy. The time to maturity would be indeed constant as we are always looking at 1 month options in the case of the BuyWrite index. However, the graph above indicates massive swings in the 3 year monthly rolling volatility for the EURO STOXX 50 Index. Therefore, the implied volatility of the options for the time between 04/2003 and 01/2008 would have been low and therefore would have reduced the option premiums received from selling calls. In contrast, during the financial crisis implied volatility would have been much higher; hence the premiums received from selling call options during this period should have resulted in better returns than indicated in the table above. Indeed, the chart of the performance of the Lyxor ETF EURO STOXX 50 BuyWrite proves that point as the ETF outperformed the EURO STOXX 50 Index by 8.5% in 2008.
Also, interest rates have changed over the period in question, reaching their nearby peak in 2008 before declining to their current historically low levels. Even though interest rates are an ingredient in the option pricing formula, the impact of a change in interest rates on option prices is generally very low; especially when we are looking at one month options.
This leaves us with volatility being the major variable impacting our option price assumptions. Nevertheless, in our case, volatility works both ways, with higher volatility increasing the prices of call options--meaning the premiums received by the seller would be greater. At the same time, higher volatility also increases the odds that the index’s monthly returns will exceed 4% (the assumed level of the options’ strike price above spot in our example) and therefore would result in underperformance. It could be argued however, that high volatility is more beneficial to this strategy over time as the table below indicates.
Index Construction
The EURO STOXX 50 Index includes 50 companies. To be eligible for inclusion a company must be headquartered in a country of the EMU. Each eligible company is then ranked by market-capitalisation and the 40 largest are automatically included. The next ten are chosen from the companies ranked 41st to 60th with preference given to existing components to reduce turnover. The index is weighted by free-float adjusted market capitalisation, with each component capped at a maximum of 10% of the index’s total value. Full reviews are done in September of each year, but there are criteria which can turn over components sooner, such as a bankruptcy, merger or events causing a component to otherwise slip from the ranks of the top 75. German, French, Spanish and Italian companies account for about 90% of the index, with the remainder spread amongst another eight countries. Although at first glance it looks concentrated amongst those four main countries, the companies in the index tend to be multinational corporations with operations all over the world, minimising risks from geographic concentration.
The BuyWrite Index sells call options on the EURO STOXX 50 Index to generate additional income. The index call option is rolled over monthly. Each third Friday of the month, a call option with a maturity of one month is sold. The option has to be 5% out-of-the-money, i.e. the highest strike price below or equal to the EURO STOXX 50 Index settlement price plus 5%.
As with all indices, this is only a theoretical calculation and does not involve an actual option investment. The option price will simply be embedded in the index calculation to achieve the return for the underlying index plus the option premium.
Fund Construction
As with all ETFs from Lyxor, this ETF uses swap-based replication to track the performance of the EURO STOXX 50 BuyWrite Index. Instead of holding the actual index securities as in a physically-replicated ETF, the fund holds a substitute basket of securities which may or may not resemble the index. In this case, the substitute basket is composed of European equities. Lyxor then enters into an OTC swap in which it exchanges the performance of this basket for the benchmark’s return. While Lyxor must solicit third-party bids for its swaps, the swap counterparty is always Société Générale, Lyxor’s parent bank. In those instances where Lyxor engages a third-party swap counterparty, Société Générale will guarantee the swap, providing an additional layer of protection for investors. UCITS requires that the individual counterparty exposure be limited to 10% of the fund's net asset value (NAV), but Lyxor typically resets the swaps when the fund’s exposure reaches a level representing 5-7% of the fund’s NAV, or whenever there is a creation or redemption at the fund level. Lyxor does not engage in securities lending within its ETFs. Dividends are accumulated throughout the year and held in a ‘cash bucket’ until they are distributed to fund holders once a year. This dividend treatment can potentially create a drag on returns in upward trending markets because dividends are not reinvested into the fund. In practice this cuts both ways. It could also result in outperformance if the benchmark falls.
Conclusion
In summary, this investment strategy is most suitable during uncertain non-directional market environments and in particular during periods of high volatility. As we have seen previously, this strategy has a lower level of volatility as compared to the plain-vanilla index. This is due to the fact, that the covered call caps the up-side and the option premiums received serve as a downside buffer. The main weakness of this strategy is the limited upside participation it offers--which most recently hurt its performance during the EURO STOXX 50’s bull run in 2009.
