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3 Benefits of a ‘Complicated’ Covered Call Strategy

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“I don’t know why this strategy isn’t written about more in the press,” Marty Sass innocently remarked. “Maybe it sounds too complicated.”

The strategy to which Sass referred is “covered call option writing against attractive equities with growing dividends combined with the purchase of index put options for downside protection.”

Not complicated at all.

While it might sound facetious, when the CEO and chairman of independent investment management firm MD Sass with $8 billion under management, explained the strategy, it really is easily understood.

“It has three ingredients,” Sass told ThinkAdvisor on Thursday. “The first is buying undervalued, high quality stocks with better yields than the S&P 500 delivers. The second is selling covered calls with attractive premiums out of the money. The last is buying index puts out of the money for additional downside protection.”

It currently results in cash flow from dividends that average 2.5%, compared with 2.1%the market is currently yielding. The option premiums result in added income of 8.8% annualized. Combine the two and the client is currently looking at 11.3% annualized. Take 1% away for the cost of the index put protection and 75 basis points for the funds fee, and it results in a net annualized return of around 9%.

Marty Sass

“And that’s just if the markets stay neutral,” Sass (left) added. “Even if the market deceases, the put options and cash flow provide a great deal of cushion.

So how did he hit on such a strategy? Maybe it’s M.D. Sass’ 40 years in the business. The firm, founded in 1972, “has been doing this long before the CBOE. There are very few managers doing it. It’s not new, but sounds complex.”

On June 28, M.D. Sass launched a mutual fund utilizing this same strategy which the firm has employed for large institutional portfolios. Sass, who also manages a hedge fund and a long-only equity strategy, nonetheless said it’s like a long/short equity hedge fund strategy, but without the “2 and 20” typically charged. He claims it’s also outperformed they HFRI Equity  Hedge Index by 4.8% annually since its inception in June 2009.

“That 11.3% net annual return compares with 6.5% the equity hedge fund benchmark, and it’s been achieved with significantly less risk. With a bond market in what we believe is a multi-decade bear market, where will clients get income? You don’t want to put everything in equities, so this is a compelling option.”

Four stocks Sass would recommend currently for this strategy are: International Paper (IP), Williams Cos. (WMB), Foot Locker (FL) and Teva Pharmaceuticals (TEVA).

“The sharp rally in stock prices, heightened market volatility and declining bond prices makes the current environment challenging, he concluded. “Investors are gravitating away from bonds and toward equities for income and yield have a new source of potential positive cash flow generation through high quality dividends, options and hedging techniques. As the investment landscape becomes more uncertain with increasing interest rates looming, advisors and investors are looking for products that offer potential equity-like returns without the increased risk associated with the equity markets.”