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Picking Up Premium on Quality Stocks

Mike Nazwaski

Picking Up Premium on Quality Stocks

Snapshot
If buy-and-hold is a component of your investment strategy, the addition of BMO Canadian High Dividend Covered Call ETF (Ticker: ZWC) can improve a portfolio’s return characteristics. 

  • Our buy-and-hold Income Equities portfolio seeks higher yield and lower beta equity returns in order to complement our active risk management strategies.
  • ZWC contributes to this objective by holding high-quality dividend stocks while earning option premiums through a systematic call-writing program.

Details
BMO Canadian High Dividend Covered Call ETF (Ticker: ZWC)

Benefits
The interest rate market is pricing the expectation the Bank of Canada will lower its overnight rate target by at least 25 basis points this year. It is becoming increasingly difficult to earn a decent risk-adjusted yield, since the interest rate curve is flat/inverted out to 10 years.

Trade Idea
The goal of ZWC is to generate a higher yield than a dividend-only portfolio without giving away too much upside. It is a sector-diversified and yield-weighted portfolio of Canadian dividend stocks screened for quality. As well, these names must have a liquid, tradable options market. BMO portfolio managers enhance the returns of this portfolio by systematically writing calls on the underlying positions. This process generates significant pickup with a current annualized distribution yield of 6.82%, compared to the BMO S&P/TSX™ Capped Composite Index ETF (Ticker: ZCN) yield of 2.87%.1 

A concern with call-writing strategies is the risk that the underlying stock will be called away and reduce performance. Our research indicates this portfolio approach with a defined options overlay strategy mitigates much of that risk. ZWC was launched only three years ago, so to test this we have run studies using the historical price data of BMO's first call writing strategy, BMO Covered Call Canadian Banks ETF (Ticker: ZWB). ZWB employs a similar process to earn options premium on Canadian bank stocks. It is a good proxy to test the hypothesis that ZWC would add value to a portfolio.

Since 2011, ZWB has, on an annual total return basis, participated in 89% of the upside of BMO Equal Weight Banks Index ETF (Ticker: ZEB) and 80% of the downside.2 It’s also insightful to analyze how ZWB performs when the underlying bank stock index moves at extremes. Of the nine years since launch, the best three years for bank stocks produced an average annual return of 22.4% while ZWB returned 18.6%.1 The average of the three worst years for banks was -4.7%, versus -3.8% for ZWB.1 Another measure that underlines the defensive nature of this strategy is the maximum peak-to-trough move of both ETFs. Over the nine years, ZEB’s maximum drawdown was 13.9%, versus 12.2% for ZWB.1 These are the kinds of results our systematic active risk management strategies seek.

For example, over the same nine-year period the S&P/TSX 60™ (using Horizons S&P/TSX 60™ Index ETF (Ticker: HXT), a total return index) recorded an annual maximum drawdown of 18.6%, versus our proprietary systematic trading signals’ 8.0%.3 On the flip side, our S&P/TSX strategies participated in 74% of the average annual gain, versus only 21% of losses.4 ZWC and our systematic process are two different approaches to risk management, which we employ to maximize risk-adjusted returns at the portfolio level.

For ZWC, similar results could be expected over the coming years. We looked at the top 25% of the past 36 months of HXT returns and compared them to those of ZWC. The best months averaged 3.8% for HXT and 3.2% for ZWC. For the worst 25%, HXT averaged -2.8% versus -2.4% for ZWC. Looking at drawdowns, the maximum over this time period was 18.6% for HXT versus 10.1% for ZWC.1, 3

Finally, the correlation of ZWC, HXT and Inukshuk Capital Longevity Portfolio’s monthly returns to each other reduces portfolio risk. Over the past three years, ZWC is 95.5% correlated to HXT and only 47.1% correlated to our systematic strategies. And our strategies are only 54% correlated with the S&P/TSX 60.1, 3, 4

Outlook
If one of your goals is to invest in dividend stocks in a diversified manner and hold them for the long term, a portfolio of stocks screened for quality with a professionally managed options overlay can improve total risk-adjusted returns. The risk of losing upside gains is mitigated by the systematic process of the managed strategy, while generating additional income earned by capturing option premiums on quality stocks.

 

 Visit the Inukshuk Capital Management website >

 

 

1 BMO Global Asset Management, as of January 29, 2020.

2 BMO Global Asset Management, January 1, 2011 – January 29, 2020.

3 Horizons ETFs, as of January 29, 2020.

4 Inukshuk Capital Management Inc., as of January 29, 2020.

Mike Nazwaski

Picking Up Premium on Quality Stocks

Snapshot
If buy-and-hold is a component of your investment strategy, the addition of BMO Canadian High Dividend Covered Call ETF (Ticker: ZWC) can improve a portfolio’s return characteristics. 

  • Our buy-and-hold Income Equities portfolio seeks higher yield and lower beta equity returns in order to complement our active risk management strategies.
  • ZWC contributes to this objective by holding high-quality dividend stocks while earning option premiums through a systematic call-writing program.

Details
BMO Canadian High Dividend Covered Call ETF (Ticker: ZWC)

Benefits
The interest rate market is pricing the expectation the Bank of Canada will lower its overnight rate target by at least 25 basis points this year. It is becoming increasingly difficult to earn a decent risk-adjusted yield, since the interest rate curve is flat/inverted out to 10 years.

Trade Idea
The goal of ZWC is to generate a higher yield than a dividend-only portfolio without giving away too much upside. It is a sector-diversified and yield-weighted portfolio of Canadian dividend stocks screened for quality. As well, these names must have a liquid, tradable options market. BMO portfolio managers enhance the returns of this portfolio by systematically writing calls on the underlying positions. This process generates significant pickup with a current annualized distribution yield of 6.82%, compared to the BMO S&P/TSX™ Capped Composite Index ETF (Ticker: ZCN) yield of 2.87%.1 

A concern with call-writing strategies is the risk that the underlying stock will be called away and reduce performance. Our research indicates this portfolio approach with a defined options overlay strategy mitigates much of that risk. ZWC was launched only three years ago, so to test this we have run studies using the historical price data of BMO's first call writing strategy, BMO Covered Call Canadian Banks ETF (Ticker: ZWB). ZWB employs a similar process to earn options premium on Canadian bank stocks. It is a good proxy to test the hypothesis that ZWC would add value to a portfolio.

Since 2011, ZWB has, on an annual total return basis, participated in 89% of the upside of BMO Equal Weight Banks Index ETF (Ticker: ZEB) and 80% of the downside.2 It’s also insightful to analyze how ZWB performs when the underlying bank stock index moves at extremes. Of the nine years since launch, the best three years for bank stocks produced an average annual return of 22.4% while ZWB returned 18.6%.1 The average of the three worst years for banks was -4.7%, versus -3.8% for ZWB.1 Another measure that underlines the defensive nature of this strategy is the maximum peak-to-trough move of both ETFs. Over the nine years, ZEB’s maximum drawdown was 13.9%, versus 12.2% for ZWB.1 These are the kinds of results our systematic active risk management strategies seek.

For example, over the same nine-year period the S&P/TSX 60™ (using Horizons S&P/TSX 60™ Index ETF (Ticker: HXT), a total return index) recorded an annual maximum drawdown of 18.6%, versus our proprietary systematic trading signals’ 8.0%.3 On the flip side, our S&P/TSX strategies participated in 74% of the average annual gain, versus only 21% of losses.4 ZWC and our systematic process are two different approaches to risk management, which we employ to maximize risk-adjusted returns at the portfolio level.

For ZWC, similar results could be expected over the coming years. We looked at the top 25% of the past 36 months of HXT returns and compared them to those of ZWC. The best months averaged 3.8% for HXT and 3.2% for ZWC. For the worst 25%, HXT averaged -2.8% versus -2.4% for ZWC. Looking at drawdowns, the maximum over this time period was 18.6% for HXT versus 10.1% for ZWC.1, 3

Finally, the correlation of ZWC, HXT and Inukshuk Capital Longevity Portfolio’s monthly returns to each other reduces portfolio risk. Over the past three years, ZWC is 95.5% correlated to HXT and only 47.1% correlated to our systematic strategies. And our strategies are only 54% correlated with the S&P/TSX 60.1, 3, 4

Outlook
If one of your goals is to invest in dividend stocks in a diversified manner and hold them for the long term, a portfolio of stocks screened for quality with a professionally managed options overlay can improve total risk-adjusted returns. The risk of losing upside gains is mitigated by the systematic process of the managed strategy, while generating additional income earned by capturing option premiums on quality stocks.

 

 Visit the Inukshuk Capital Management website >

 

 

1 BMO Global Asset Management, as of January 29, 2020.

2 BMO Global Asset Management, January 1, 2011 – January 29, 2020.

3 Horizons ETFs, as of January 29, 2020.

4 Inukshuk Capital Management Inc., as of January 29, 2020.