Getting your UK equity income allocation right: not all covered call strategies are equal

The price-to-earnings ratio for the FTSE 100 currently stands at 17.5x

Morgane Delledonne

Senior Associate, Investment Strategist, Exchange Traded Funds

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Risk Disclaimer

Past performance is not a guide to future performance. The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Shares purchased on the secondary market cannot usually be sold directly back to the Fund. Secondary market investors must buy and sell ETF Shares with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current Net Asset Value per Share when buying ETF Shares and may receive less than the current Net Asset Value per Share when selling them.

Opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

The price-to-earnings ratio for the FTSE 100 currently stands at 17.5x, which is almost one standard deviation below its five-year average (26.9x) and reflects the discount resulting from the significant political uncertainty. This makes the FTSE 100 look very attractive versus other major developed markets.

 

A covered call strategy provides extra income that can act as a buffer in bear markets whilst also allowing upside participation, but beware – not all covered call strategies are the same, and some could introduce unintended characteristics into your portfolios.

Risk Disclaimer

Past performance is not a guide to future performance. The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Getting your UK equity income allocation right

The renewed weakness of sterling amid the UK’s seemingly never-ending political uncertainty will likely benefit the FTSE 100 index. Around two-thirds of the index’s constituents derive their earnings overseas and so have limited global direct exposure to the UK economy, and therefore little or no impact from a potential hard Brexit. Utilities and financials are the most sensitive sectors to Brexit risks but companies in these industries represent only one-fifth of the index.
 

FTSE 100 looks very attractive versus other major developed markets

The price-to-earnings ratio for the FTSE 100 currently stands at 17.5x, which is almost one standard deviation below its five-year average (26.9x) and reflects the discount resulting from the political uncertainty around the Conservative party’s leadership contest, and therefore who will be the UK’s next Prime Minister. The outcome of the contest will have major implications for the Brexit endgame, after three-years of wrangling, and has significantly increased the prospect of a no-deal. This is considered by the majority of domestic companies to be the worst Brexit scenario, and has therefore materially impacted sterling. However, for the FTSE 100, where the majority of constituent companies convert their global earnings back into sterling, this makes for a very attractive current opportunity compared to other major developed market indices.
 

How we capture the FTSE 100

The BMO Enhanced Income UK Equity strategy physically replicates the FTSE 100 index as a core holding with no active bet* and has a covered call overlay to enhance the overall yield of the fund. A covered call strategy will typically underperform the replicated index in periods when the underlying market is strongly rising and outperform when the market is falling or trading range-bound.

In order to enhance yield without forfeiting the entire potential upside participation, the BMO Enhanced Income UK Equity ETF sells index call options against approximately half of the equity portfolio, thus combining income and investment growth.
 

Not all covered call strategies are equal

There are other covered call UK equity strategies in the market, such as the Schroder UK Income Maximiser, which generates a similar overall fund yield to that of the BMO offering, at around 7% per annum. However, the Schroder fund employs a different approach, to achieving its yield, which can lead to very different fund characteristics, which is important for those investors considering how their UK equity allocation will affect their overall investment portfolio.

The BMO UK Enhanced Income strategy uses index call options, which mitigate idiosyncratic risks, while its Schroder peer sells single name call options. Furthermore, the Schroder fund has a notable bias to value stocks, giving it a large overweight in Financials (32% versus 19% of the FTSE 100 index), which is a sector much higher at risk from a possible hard Brexit, and also has a higher exposure to small and mid-cap stocks than the FTSE 100 index – stocks that tend to be more exposed to domestic revenues than their larger counterparts.

The other differentiating factor about the BMO Enhanced Income UK Equity strategy, is that it targets between 40% to 60% coverage in a systematic manner, depending on volatility.
 

Mitigate risk with liquidity and low cost

Year-to-date, the BMO Enhanced Income UK Equity ETF (ZWUK LN) has outperformed the Schroder UK Income Maximiser by 8.2% amid rising UK equity markets as of 24 June 2019. The BMO UK Enhanced Income ETF is significantly more cost effective – with an ongoing charges figure (OCF) of 30 basis points versus the Schroder fund’s 91 basis points. The BMO Enhanced Income ETF range holds the securities in the FTSE 100 – the most liquid of the London-listed indices and can also benefit from access to the secondary market for ETFs, which helps to match orders between buyers and sellers on exchange without stamp duty, meaning that investors can be confident in the BMO ETF’s competitive liquidity.

Shares purchased on the secondary market cannot usually be sold directly back to the Fund. Secondary market investors must buy and sell ETF Shares with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current Net Asset Value per Share when buying ETF Shares and may receive less than the current Net Asset Value per Share when selling them.

Opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

* The 5/10/40 UCITs rule constrains our holding of Royal Dutch Shell which is underweight at the moment compare to the benchmark.