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) Managing 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.
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.
Exhibit 1: Option premium increased when market volatility heightened (Asia equities example)2
Goal 2: Capturing capital upside potential
The pursuit of higher income should not necessarily mean forgoing all upside potential in equity markets. A hybrid strategy that pairs a dividend-paying portfolio with option writing on a portion of the portfolio 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 part of the portfolio will allow investors to retain exposure to the potential upside of long term growth of equities3.
Goal 3: Managing risk
Income seekers often invest in fixed income in the search for yield, which may accumulate 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.
Conclusion
While some investors may believe that the three goals of 1) Seeking higher income, 2) Capturing capital upside potential and 3) Managing risk 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.