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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 coveredcall
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.
Covered-Call Returns
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
Figure 1
Equity Covered-Call ETFs/ETNs
Equity Covered-Call
ETFs/ ETNs
Bloomberg
Ticker
Country/
Region
BMO Covered-Call Canadian Banks ZWB:CN Canada
Horizons Enh Inc Equity HEX:CN Canada
Horizons Enh Inc Financials HEF:CN Canada
Can-60 Covered Call LXF:CN Canada
Can-Energy Covered Call OXF:CN Canada
Can-Financials Covered Call FXF:CN Canada
Can-Materials Covered Call MXF:CN Canada
Lyxor ETF EURO STOXX 50 BuyWrite BWE:BQ Europe
MIDAS KOSPI200 Covered Call 137930:KS Korea
PowerShrs S&P 500 BuyWrite PBP:US US
iPath S&P 500 BuyWrite ETN BWV:US US
Source: Bloomberg
Figure 2
BRIC
Country
Availability Of Exchange-Traded Instruments
In BRIC Countries For Covered-Call Construction
Stock
Index
Source: Local exchanges
Stock
Index
Futures
Options
on Stock
Index
Options
on Index
Futures
ETF on
Index
Brazil Ibovespa Yes No Yes Yes
Russia RTS Yes No Yes Yes
India NIFTY Yes Yes No Yes
China CSI 300 Yes No No Yes
March / April 2013 53