Deconstructing Covered Call Funds & The Fires in Ecuador

A few things today starting with wildfires in Ecuador.

Ecuador has been a favorite retirement destination for American expats for quite a while. We've written about Ecuador in this context several times and followed up in the last couple of years as political and social volatility has escalated. It seems to have mostly impacted Quito while it has primarily been Cuenca that has been the expat destination. Now the wildfires which Bloomberg says are threatening Quito. 

Wildfires have also become far more common in other expat destinations, notably Portugal, Greece and to a lesser extent, Spain. One component of expat living that I hit on in every post about it is the suggestion of keeping a paid off home in the US, renting it out and taking in that income stream. It provides an escape hatch if you need to come back for any reason. The odds of being priced out five or ten years after you leave are pretty high. 

The reasons someone would need or want to come back could include health reasons or some sort of serious political upheaval. Now, we need to add climate change to that list? Regardless of where anyone stands on climate change, there have been more wildfires beyond the American west and, knowing a little about this subject, it is not obvious they really know how to manage wildfires in some of these places. When you roll up on a couple of acres on fire, it can be as simple as put the wet stuff on the red stuff, but the incidents occurring in these places, like Ecuador and Portugal now, are far more complex. 

If you move someplace you think is beautiful and then it burns down, maybe you wouldn't want to come back to the US but it would be nice to have the option. 

I sat in on a webinar about model portfolios which turned out to just be a sales pitch, I was hoping to take in a little about portfolio construction process. The webinar whiffed on that but toward the end there was one useful nugget, more of a confirmation of what we talk about here all the time. 

One of the presenters talked about predictability being a feature of the models they build. I have no idea if their models offer any predictability or not but it is a priority in how I do my job and like I said, we talk about here all the time. We talked about it just yesterday with this graphic.

Adding tech should increase volatility and longer term should add to performance and utilities should do the opposite. There are times in the cycle where more volatility is good and other times where it is not ideal. If you don't think you can predict when you'd want less volatility (most people won't be able to do this) then you need to figure out how to build a portfolio that can let you endure the entire cycle. 

I didn't mention this yesterday when I posted that image but in 2022. the XLU blend was down 16.23%, SPY was down 18.19% and the XLK blend was down 19.14%. That is a great example of the predictability referenced in that webinar and what I mean when I am talking about it. The utility blend should hold up a little better in a serious decline. It may not always do so, there is no guarantee, but that is a reasonable expectation to have. 

Then I sat in on a second webinar put on by ProShares about their suite of 0dte covered call funds. I've disclosed owning the ProShares S&P 500 High Income ETF (ISPY) which is part of this suite. I bought it when it first listed to test drive it for possibly adding across the board in client accounts. When you listen to these presentations you really need to sift through the sales pitch aspect of them and this one was no different. 

A big part of the pitch here is better upcapture than the monthly products. We talk all the time about Global X S&P 500 Covered Call ETF (XYLD) which is a monthly call writing strategy and how little it participates in the stock market's upside. According to Yahoo Finance, in the last five years XYLD is down 16% on a price basis. If you spent all the dividends, you'd be down 16%. To be clear, that is not the total return but we are talking about upcapture and XYLD hasn't had any. In the same five years, the S&P 500 is up about 88%. 

In the sales deck they put up a table that only went through June 30th and showed ISPY being very close to the S&P 500. I thought I heard them to say on a price basis but when I looked at all the of the charts they said total return. Maybe I misheard but I tried to make sure I had it right, they were talking about total return.

The above is the index underlying ISPY not the fund, so it goes back further. The total return (price plus yield) in that graphic shows upcapture of just under 90%. Does it stand up in the real world?

Yahoo only tracks price return, not total return. ISPY had paid out $3.10 so far this year which would tack another 7.6% in total return in addition to the 13.2% of price gains. So the NAV upcapture is about 2/3rds and the total return, based on Yahoo's numbers is close to even with the index. I threw the Global X S&P 500 Covered Call & Growth ETF (XYLG) into the chart. That fund sells monthly calls on half the portfolio. In addition to the 13% price gain, you'd add in another $1.06 in dividends which works out to another 3.7% to the total return which is a little less than the total for ISPY. Rounding it out, XYLD has paid $2.89 in dividends this year which adds another 7.3% in total return to the 4.5% from the chart.

Here are the volatility numbers for all four through 8/31.

There was a very interesting chart in the presentation that they spent almost no time on about how to size ISPY into a portfolio.

I have no idea if they actually meant to cut plain vanilla equity exposure in half to add this type of fund in but that is way too much for me. My interest would more complementary that as a core.

There's a lot going on with the next backtest.

Portfolio 1 is 85% SPY and 15% XYLG which goes back much further than ISPY. Portfolio 3 is just SPY. Portfolio 2 is a combo of Invesco Momentum (SPMO) and XYLG that is risk weighted almost the same as 100% in SPY. Blending SPMO and XYLG that way gave a return that annualized out 50 basis points better than 100% SPY which is interesting. Additionally, that blend was only down 11.52% in 2022 thanks to a relatively good year for momentum as we discussed yesterday.

And the portfolio income from this backtest.

We only have five years (partial and full) to study and Portfolio 2 was the best performer in two years and the worst performer in three times. The overall back test is appealing but it would be emotionally challenging to hold. Every valid portfolio we could possibly come up with will struggle at times, there's no getting away from that. 

So, is any of this worth it? You may read this post and decide it is not worth it and that's ok, you'd have put in some time to study and then ruled something out. That's productive in my opinion. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.