UK equities could come under pressure in the event of prolonged Brexit negotiations. In times of market turbulence, covered call overlay strategies can generate additional income and reduce the volatility associated with the underlying holdings.
While the effect of the Brexit negotiations on the UK economy remains mostly muted, real GDP growth is losing momentum. Sterling’s weakness has pushed headline inflation higher, posting a 3% rise year-on-year in October, eroding economic growth. In an effort to balance inflation concerns against unconvincing macroeconomic data, the Bank of England (BoE) raised interest rates by 25 basis points (bps) at its November meeting. Market participants are now anticipating another 25bps increase in June next year, which is consistent with BoE Governor Carney’s statement of “two rate hikes over the next three years”. This “dovish hike” did not prevent sterling from continuing to fall against major currencies, lending support to the FTSE 100 Index. Since the Brexit vote, UK exporters have benefited from global trade momentum as well as currency translation gains from foreign earnings which have had a positive impact on earnings. However, the challenges in agreeing the EU Withdrawal Bill details as well as the political wrangling within the UK government may well lead to delays in corporate investment.
The loss of economic growth momentum could prompt a search for diversifying investment opportunities that lie beyond the traditional asset classes. Equity index covered call strategies provide investors with a long exposure to the underlying equity index as well as generating an alternative income stream resulting from the writing of call options on the underlying index, with the aim of lowering the overall volatility of equity returns. Because most investors are risk averse, there is a structural excess demand for hedging equity positions. Typically, option market implied volatility is higher than the realised volatility – known as the ‘volatility risk premium’. Overall, this strategy has better risk-adjusted returns in the long run than those of the equity market, plus an additional yield above the regular dividend yield. For investors seeking income generation, the defensive nature of a covered call overlay strategy makes it an attractive alternative to money markets. Covered call strategies also present attractive diversification characteristics for fixed income investors as they do not have duration risks while generating monthly income.
Typically, covered call strategies tend to outperform the market in range-bound or down markets, and underperform in sharply rising markets. By writing call options on approximately 50% of the portfolio, our strategy also allows upside participation. Based on simulated performance of a covered call option overlay strategy on the FTSE 100 Index over the past five years, the strategy outperformed 80% of the time in a bear market and 67% of the time in a flat market.
This strategy is also available for European and US equity markets.