Pairing a dividend-paying portfolio with call option writing can be a solution to address the currently challenging yet crucial needs.
Achieving 3 goals with 1 high income equity strategy
Traditional dividend investing has stood the test of time as a proven approach to capture income opportunities. Within any diversified asset allocation, an equity income strategy plays an important role as a source of income while presenting opportunities for capital gains. While this still holds true, markets are more dynamic than ever and we observe an increasing need for clients to balance multiple goals – 1) Seeking higher income, 2) Capturing capital upside potential and 3) Mitigating risk. We believe pairing a dividend-paying portfolio with call option writing1 can be a solution to address these challenging yet crucial needs.
Goal 1: Seeking higher income
While traditional dividends are the core of any equity income strategy, less conventional methods like writing call options on the underlying portfolio can help generate additional income. By writing call options1 (i.e. selling a portion of capital upside potential), one can transform potential capital gains into a consistent stream of income. Additionally, in times of higher market volatility, one can also observe higher option premium received as income.
As illustrated in Exhibit 1, additional income obtained in the form of option premium can help enhance income profile of a portfolio and hedge against the downside when market volatility heightened,smoothing out total return of a portfolio and lowering volatility relative to the broad market.
Exhibit 1: Option premium serves as incremental income²
Goal 2: Capturing capital upside potential
The pursuit of higher income should not necessarily mean forgoing all upside potential in equity markets, particularly in Asia. A hybrid strategy that pairs a dividend-paying portfolio with option writing on a portion of the portfolio (~30%) could provide a balance between income generation and capital appreciation.
With option premium complementing a part of the income stream, this allows greater flexibility in the stock selection process. In addition to high-dividend companies, one can invest in higher growth but lower yielding stocks to seek for capital upside potential. Selling call options on 30% of the portfolio will allow investors to retain exposure to 70% of the potential upside of long term growth of Asian equities3.
From a geographical allocation standpoint, Asia Pacific is a region that equity income investors should keep an eye on. As illustrated in Exhibit 2, over the past 15 years, Asia Pacific companies tend to have higher dividend payouts than US companies, presenting greater income returns for income seekers. Furthermore, Asia Pacific comprises both emerging and developed markets, allowing a more diversified investment universe.
Exhibit 2: Asia Pacific companies have higher dividend payouts⁴
Goal 3: Risk Mitigation
Rapid interest rate hikes since 2022 have prompted income seekers to turn to fixed income in the search for a higher yield, accumulating excessive duration risk in portfolios. Fixed income securities such as investment grade and non-investment grade bonds are also sensitive to credit risk.
We believe an equity income strategy that combines a long equity position with a short option position can provide investors with a differentiated risk profile – one which is not exposed to duration risk and credit risk that usually come along with bonds.
While some investors may believe that the three goals of 1) Seeking higher income, 2) Capturing capital upside potential and 3) Risk mitigation are mutually exclusive, we believe that a higher equity income strategy may help investors move closer to these objectives, bringing fruitful results in the long run.