The role equity income ETFs can play when navigating market volatility

*This article is produced in partnership with J.P. Morgan Asset Management Australia

Recent banking sector stress in the US and Europe, persistent inflation and the actions of some major central banks have left markets in turmoil and investors uncertain about the future. Some investors are rethinking their approach to generating income – continue to hold cash and core bonds or extend into higher-yielding markets such as equities but stomach the risk and volatility?

An uncertain market outlook is prompting some investors to be creative and to be outcome-oriented¹, employing strategies that allow them to stay invested through various market conditions while hedging against down-market volatility. Some of these strategies aim to generate income through equity options-based solutions.

The income-seeking approach of  one exchange-traded fund (ETF) strategy comprises two building blocks – investing in an actively managed portfolio of defensive US large cap stocks and selling S&P 500 Index² call options – as the investment managers seek to deliver a consistent income stream from associated option premiums and stock dividends³. This unique strategy seeks to generate consistent annualised income⁴, distributed monthly, with two-thirds of the volatility and beta of the S&P 500².

Source: J.P. Morgan Asset Management. Provided for information only, to illustrate underlying portfolio and asset class characteristics.⁵

For income-oriented or total-return investors, such an equity options-based solution can present relatively attractive opportunities for income⁶ in an overall portfolio. It can also act as an equity alternative where investors can seek to boost income with lower volatility, while forgoing a portion of the market’s upside.

Not all option-writing strategies⁵ are created equal.

Some option-writing strategies don’t look to time the market, and these strategies often have investment managers with deep expertise in implementing the options process.

In the approach of one unique strategy, the options overlay consists of selling S&P 500 Index² options that are one-month, out-of-the-money call options. At the same time, in order to dynamically adjust the upside and income to the volatility landscape, the options reset a portion of the options on a rolling weekly basis. This approach allows the investment managers to better balance income with total return.

When volatility goes up, options tend to get more expensive. Because the strategy is selling options, they tend to be relatively attractively valued. In other words, it seeks to optimise the market’s upward advantages and more income⁴.

What are the key considerations for an equity premium income ETF⁵?

1. The ETF strategy may not capture all of the market’s upside

The strategy is designed to enhance distributable income comprising dividends and options premium. In return for the option premium, an investor may forgo a portion of the market’s upside.

One building block of the strategy is an underlying equity portfolio that is more conservative in nature, with less market beta and volatility. More defensive equities can help because when markets fall, a high-quality, low-volatility equity portfolio is better positioned to withstand such volatility.

2. Positioning for different market environments

• Falling markets – such a conservative equity portfolio seeks income to buffer possible downside
• Sideways or gently rising markets – seeks capital appreciation and income
• Rising markets – can potentially forgo some upside for income

3. Varying distributable income

The options premium generated can vary, depending on prevailing volatility – when volatility increases, both income opportunities and the potential for capital appreciation also increase and vice versa.

Conclusion

Combining prudent, disciplined call writing with an active equity portfolio can help solve a number of objectives⁷. The pairing can serve as a way to access low-volatility equity exposure, a yield-generating supplement for credit or a component of a more diversified income-generation strategy.

What are call options8?

An option is a contract that provides a buyer with the right, but not the obligation, to buy or sell a specific financial product known as the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, ETF or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon. Contracts also have an expiration date, a period that could be as short as a day or as long as a few years. When an option expires, it no longer has value and no longer exists. If investors buy a call, they have the right to buy the underlying instrument at the strike price on, or before the expiration date. On the other hand, selling a call option gives the seller the obligation to sell the underlying instruments at the strike price. In return, the seller is paid a premium. A call option is in-the-money if the current market value of the underlying stock is above the strike price of the option. The call option is out-of-the-money if the stock is below the strike price9. For example, if a stock is trading at $50 per share, while the investor has a strike price at $70 and owning a $70 call, that option would be out-of-the-money by $20.

How do covered calls work10?

A covered call strategy comprises writing a call that is covered by an equivalent long stock position. It provides a small hedge on the equity and allows an investor to earn premium income without taking on additional risk, in return for temporarily forfeiting much of the stock’s upward potential. The premium received adds to the investor’s bottom line regardless of outcome. It offers a small buffer in the event the stock slides downward and can help boost returns when it rises.

Disclaimer:

Provided for information only based on market conditions as of date of publication, not to be construed as offer, research or investment advice. Forecasts, projections and other forward looking statements are based upon current beliefs and expectations, may or may not come to pass. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties and risks associated with forecast, projections or other forward statements, actual events, results or performance may differ materially from those reflected or contemplated.

Diversification does not guarantee investment return and does not eliminate the risk of loss. 

1. For illustrative purposes only based on current market conditions, subject to change from time to time. Not all investments are suitable for all investors. Exact allocation of portfolio depends on each individual’s circumstance and market conditions.
2. The S&P 500 Index is an unmanaged index generally representative of the performance of large companies in the US stock market.
3. The Investment Manager (Portfolio Manager) seeks to achieve the stated targets/objectives. There can be no guarantee the objectives/targets will be met.
4. Returns or distributions are not guaranteed. Distribution may be paid out of capital or income or both. The manager seeks to achieve the stated objectives. There can be no guarantee the objectives will be met. There is no guarantee that companies that can issue dividends will declare, continue to pay, or increase dividends. Based on historical observations.
5. Source: J.P. Morgan Asset Management. Provided for information only, to illustrate underlying portfolio and asset class characteristics.
6. Source: “PM Corner: In conversation with Hamilton Reiner”, J.P. Morgan Asset Management, data as of 22.04.2022.
7. Source: “New Pathways to Income: Optionality”, Allocation Spotlight Series, J.P. Morgan Asset Management, 14.10.2021.
8. Source: “What is an Option?”, The Options Industry Council, January 2023.
9. Source: Basic Options Terms Explained: In-the-Money, At-the-Money, and Out-of-the-Money”, The Options Industry Council, January 2023.
10. Source: “Covered call (Buy/Write)”, The Options Industry Council, January 2023.

Source – JPMorgan Asset Management (Australia) Limited ABN 55 143 832 080, AFSL No. 376919

All investments contain risk and may lose value. The information provided on this article is general in nature only and does not constitute personal financial advice. The information has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information having regard to your objectives, financial situation and needs. Before making any decision, it is important for you to consider the appropriateness of the information and seek appropriate legal, tax, and other professional advice. Prior to making an investment decision, investors should read the relevant Product Disclosure Statement and Target Market Determination, which have been issued by Perpetual Trust Services Limited, ABN 48 000 142 049, AFSL 236648, as the responsible entity of the fund available on https://am.jpmorgan.com/au.