Equity Premium Income’s Hamilton Reiner delves into the power of alternative income strategies in an income-hungry world.

Hamilton, what do you believe is the biggest issue investors are facing today?

After a year with no shortage of volatility, many investors flocked to the safety of cash. As a result, we are seeing a great deal of money on the sidelines, as many investors today are underinvested in equities as well as searching for healthy income

One of the biggest risks facing investors is not putting their money to work. Ever since the Federal Reserve flooded the market with liquidity, keeping interest rates lower for longer, there has been a perennial problem of finding income. While the unprecedented pace at which the Fed hiked rates last year has brought some “income” back to “fixed income,” it is important to remember that inflation has also been running hotter than normal. As real yields in fixed income remain low and equity volatility may persist in 2023, investors need options.

As real yields in fixed income remain low, and equity volatility may persist in 2023, investors need options.

How can we get sufficient yield to meet investors’ income needs, while also solving for total return?

We can be creative about generating total return for investors; we do not have to make the decision between providing income and capital appreciation. Though we have seen equity markets rally quickly to start the year, we are likely facing more muted returns with higher volatility as compared to the last few years. One good way to provide this balance is an equity options-based solution, comprised of a high-quality equity portfolio and selling S&P 500 call options. Our Equity Premium Income strategy generates income by selling options and investing in U.S. large cap stocks. It seeks to deliver a monthly income stream from associated options premium and stock dividends, with reduced volatility vs. the S&P 500, no leverage and daily liquidity. There is one basic trade-off inherent in an equity options-based solution: giving away some of the stock market upside for a consistent income stream.

How do you put an equity premium income-type product to work? What roles does it serve in a portfolio?

I see three main use cases for an equity premium income-type strategy:

  • First, if you have an income model, a modest allocation can help increase income more quickly.
  • Second, it can be used as an equity alternative, as it has reduced equity beta vs. the S&P 500. Total returns can be received through dividends, options premium and some of the market’s upside over time. However, you will forgo some of the upside for potentially higher levels of income. With an equity options-based solution, you can receive above-average levels of income with reduced volatility.
  • Third, as people remain less enamored by low real yield levels and credit default risk in bonds, equity options-based strategies can be used to replace high yield, emerging market debt, or U.S. preferreds, receiving potentially more income with similar levels of beta.

High-quality stocks can act as an implicit buffer to the downside. More defensive equities can help because when markets go down, a high-quality, low-volatility equity portfolio is likely to fare better.

How do you think about the equity market risk of different income-yielding assets?

We look at yield vs. beta to the S&P 500. High yield, emerging market debt and U.S. preferreds typically have about 0.45-0.5 beta to the S&P 500. In other words, owning these assets means taking on equity market risk. If you’re going to take on this risk and seek income, think about how much income per unit of risk you’re looking for.

What we’re seeing today is that equity options-based strategies that generate income have the ability to capture more income than assets like high yield, emerging market debt or U.S. preferreds. 

How does this type of strategy perform in downside scenarios?

Our goal in constructing the underlying equity portfolio is to provide exposure that is more conservative in nature, with less market beta and volatility. High-quality stocks can act as an implicit buffer to the downside. More defensive equities can help because when markets go down, a high-quality, low-volatility equity portfolio is likely to fare better. We also strive for a highly diversified portfolio, so there is no one stock or sector that will drive an outsized portion of the returns or volatility of the strategy. To accomplish this, we’ve instituted a cap on both sector and security exposures. This results in structural underweights to some of the larger and more volatile names and sectors in the market, like info tech. In a year like 2022, this combination of higher-quality, lower-volatility exposure and diversification helped the strategy eat significantly less downside.

How do you generate significant levels of income with a defensive equity portfolio?

One way is by selling one-month, out-of-the-money S&P 500 Index call options, overlaid on top of a defensive equity portfolio. With this structure, you can receive income from dividends on the equities, and also from selling the options. When you sell out-of-the-money call options, you may give up some of the market upside while maintaining consistent long-term performance. With other covered call strategies that sell single security options, investors often see stock winners taken away and then they’re stuck with the stock losers. We want to keep our equities, so we sell options on the index. Another differentiator is converting the options premium into coupon, which means you will not have return of capital. Many covered call strategies treat their options income as capital gains, which leaves the potential for return of capital. At the end of the year, investors then need to go back and recalculate the cost basis of their holdings, which is a burdensome process. I believe treating the options income as coupon is a better approach because it sets up the potential for monthly distributable income without return of capital.

For investors who may be expecting growth to rally on the heels of a challenging 2022, is a diversified and defensive underlying equity portfolio appropriate?

2022 was a great year for the Equity Premium Income strategy. Volatility enabled this strategy to deliver more income to clients, and a structural underweight to the higher beta sectors of the market that sold off sharply provided better downside capture. However, looking ahead, it is important for investors to consider the kind of underlying equity exposure they seek based on their market expectations.

We also manage a similar strategy with an underlying equity portfolio benchmarked to the more tech-focused Nasdaq-100. Combining the two Equity Premium Income strategies – one benchmarked to the Nasdaq-100 and the other to the S&P 500 – can help investors more closely align their sector exposure with that of the S&P 500, while still delivering a lower beta and volatility profile with healthy monthly income.

When you sell call options to generate income, how does volatility affect the strategy? Do you actively manage the strategy based on changing volatility?

We follow a disciplined and consistent approach without trying to time the market. Selling one-month call options, and laddering the options each week, allows us to adjust how much upside and income we can receive in differing volatility environments. When volatility goes up, options tend to get more expensive. Because we are selling these expensive options, they are more attractively valued to us. In this way, we have a chance to have our cake and eat it too: we have the potential for more market upside and more income. Especially in the current investment environment, that’s a very attractive combination.