While the global financial crisis that began in 2007 left emerging markets less affected than G-10 countries, the subsequent price behavior of BRIC stock markets highlighted once again the need for global investors to control risks through portfolio diversification. Typically within a single BRIC country, however, the means to diversify are less available or less well developed than found elsewhere. Within the ETF investment universe, the means for portfolio diversification are even further restricted. For ETFs to continue their growth among emerging markets, then, will require wider coverage of assets and employment of strategies beyond traditional passive indexation.
ETF choices among nontraditional, or so-called second-generation funds, increased notably in 2012. Active management strategies for stocks and bonds now form the basis for rapid growth in developed-market ETFs. This development, which currently lags in BRIC countries, could offer the prospect of increasing the choices for domestic as well as global investors to further diversify their local BRIC holdings and so to increase risk control. BRIC equity markets remain volatile and only mildly trending or even trendless, raising the possibility that covered-call ETFs on recognized indexes could find a foothold in that impending wave of second-generation ETFs. Historical evidence strongly supports the claim that in such an environment, a covered-call strategy delivers superior returns with less than index volatility, thereby making itself an attractive candidate for use in risk control.
Moreover, the continuing strong demand for emerging markets ETFs and investors’ need for enhanced returns in our current low-yield environment suggest that covered-call strategies targeting emerging markets could find a warm welcome in the ETF arena.
In this article, we examine the feasibility of structuring a specialty covered-call ETF to satisfy the rising demand for emerging market ETFs.
Equity Covered-Call ETFs
Covered-call ETFs presently can be found linked to stock markets in the U.S., Canada, Europe and even Korea, a borderline “emerging” market (Figure 1). However, no covered-call ETFs yet exist linked to indexes in the most prominent of the emerging markets: the BRIC countries. Figure 2 shows which BRIC markets have elements from which to construct such a covered-call ETF denominated in local currency. The requirements are simple: There must be both a convenient ability to acquire equity index exposure and an ability to sell index options. The presence of stocks or ETFs that replicate the index can satisfy the exposure requirement. It may also be possible to obtain synthetic equity exposure using index futures and cash [Slivka & Li, 2010] but this method is sometimes inconvenient, unnecessarily complicated and likely to provide more variable returns. The presence of exchange-traded index calls can satisfy the second requirement.
Any instruments used to construct BRIC covered-call ETFs should have sufficient liquidity to support continuous call writing over a multiyear period. Two countries (Brazil and Russia) have options on index futures, but not options on the index itself, making covered-call construction impractical. China presently has no options at all. India, on the other hand, appears to have the necessary requirements for covered-call construction. Index exposure can be acquired by direct purchase of stocks replicating the index, while a liquid index options market allows call writing for maturities up to one month and sometimes longer. This makes it possible to construct an ETF using a semi-passive strategy in which one-month covered calls replace written calls as they expire, a topic we next explore.
One generally recognized benefit of selling calls against long positions in stocks and indexes is that receipt of the time-premium component of the call premium can raise the return on the underlying asset above the return from holding the asset alone. Since time premium for a call is greatest near-the-money, covered-call writers seeking return enhancements often choose strike prices close to the current asset price. A second benefit is that the premium received creates a partial hedge against asset price decline. If the call is written out-of-the-money, the amount of this partial hedge is limited to the premium received. If the call is written in-the-money, the full amount of premium offers protection against loss. Investors using covered calls to protect against meaningful losses often choose options deeper in-the-money.