Strategies for boosting income from shares

There are more productive ways of gaining income from shares than relying purely on dividends and share price appreciation, writes Drew Corbett.

In a declining interest rate environment, and with ongoing concerns about risk in the equity markets, investors are finding it increasingly difficult to rely upon traditional exposures to cash, bonds or equities to deliver adequate income with reasonable levels of volatility.  

‘Income from shares’ strategies range from the simple (buying high-yielding shares like Telstra, or the banks, and collecting dividends) to the more sophisticated (buying shares, collecting the dividends and generating additional income through the sale of some of the upside price potential). 

To implement this latter strategy, an investor buys a share (or share portfolio) and simultaneously sells or ‘writes’ call options on the relevant shares. 

By selling call options, the investor is selling to the buyer of the option a right to purchase the relevant share from the investor at a certain exercise price for a fee (income).

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This form of equity income or ‘buy-write’ strategy is well established in investment practice and is especially popular when markets are sluggish or trending sideways. 

An easy way to think of this strategy is that it allows the shareholder to ‘pre-sell’ some of the future capital gain potential on the share/s – and to receive payment immediately for doing so. 

Buy write performance in varying markets 

The performance of ‘buy-write’ strategies of this type has been the subject of significant academic and empirical research. 

In August 2012, the ASX released a research paper by one of Australia’s premier finance think tanks, SIRCA.

The paper examined the risk and return characteristics of a number of rules-based equity income strategies using options over stocks traded on the ASX and compared the results to the share portfolio itself (ie, where no buy-write strategy was utilised).  

One of the main benefits of the ASX research is that it analysed a variety of mechanical or “rules-based” approaches to implementing an equity income strategy using options.

This provides a useful guide as to how such strategies can be implemented without the need to actively trade the option and equity positions.  

High-turnover, active option trading may produce good returns but also creates the risk that the trader/ fund manager may not consistently achieve the benefits that a cheaper, lower-turnover, rules-based approach can potentially deliver.  

The research (summarised in Chart 1 below) analysed 30 blue chip stocks between April 2005 and December 2011. The results of this research revealed that the buy-write approach added between 20 per cent to 60 per cent to basic share returns.   

Since the period covered by the ASX research included three very different investment cycles (the pre-GFC bull market, the GFC collapse and the patchy recovery), it is compelling reading for investors interested in the buy-write approach. 

The research confirms returns were improved using equity income investing strategies in each of these three distinct market environments – and importantly, that it continued to add value all the way through the worst of the GFC.  

In summary, this paper demonstrated share returns were improved using equity income investing strategies over the study period.

In fact, each of the various equity income strategies examined generated a higher risk-adjusted return relative to a long-only stock portfolio over the study period  – as evidenced by a higher Sharpe ratio (see Table 2). 

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The average outperformance of the strategies examined was 4 per cent per annum over and above the return of the underlying share portfolio; each of the strategies examined also reduced the variability of returns (risk) on the portfolio 

So the conclusion arising from the detailed ASX research is that buy-write strategies can add meaningful benefits to share portfolios. But what are the risks? 

Risks of buy-write investing 

Investor’s risks from buy-write investing include: 

1. The share price falls (but because the investor will generate cash by selling the call options and receiving the option premium, the downside risk is less when calls are sold than it would be if the shares were held outright); 
2. The share price rises above the strike price of the call option. In this scenario the investor will still receive some gain on the underlying share, but that gain will be capped at the level at which the call option is exercised. 

Typically, buy-write strategies can be expected to outperform a stock-only portfolio in certain market environments, namely to: 

• Outperform in a modest bull market; 
• Outperform in a range bound market; and 
• Outperform in a bear market.

However, as buy-write strategies involve forgoing some of the return from the price appreciation of the relevant securities, such strategies can be expected to underperform in a strongly rising market. 

How to gain access 

Investors can implement buy-write strategies in a number of ways. The first method would be directly or through a broker but can be complex, time-consuming and expensive. 

Another alternative would be to purchase a traditional actively managed fund which can be expensive and also involves relatively higher levels of active trading risk. 

The final option is through a rules-based exchange-traded product with limited active discretion, which is likely to be cheaper than the first two alternatives, is transparent and available to buy like any share on the ASX.

Currently, there is one such product available on the ASX, which trades under the ticker ‘YMAX’. 

As investors continue to look for assets which generate income in a low interest rate environment, a buy-write strategy provides an attractive approach for those looking for yield from equities.

With the potential for less volatility and higher income than exposure to the share market alone, many portfolios could benefit from this popular strategy. 

Drew Corbett is head of investment strategy at BetaShares.