This article is part two in a four part series. To read the part one please click here.
In this case…
The Strategic Super Investor has provided three professional SMSF advisors with different investor scenarios to manage for 12 months. In our Summer issue, they allocated a portfolio according to the circumstances of their particular case. This month they track their portfolios, comment on performance and adjust if necessary.
• Outperformance of the ASX 200 Accumulation Index (ASX 200 including dividends) by 2.23% p.a. during periods of bull markets, bear markets and sideways markets.
• Total risk (standard deviation) of the buy-write portfolio is smaller than the total risk of an underlying index
• The risk-adjusted return of the buy-write portfolio, as measured by the Sharpe Ratio, outperforms the risk-adjusted performance of the index portfolio: 0.168 versus 0.067. That is, the buy-write portfolio is able to generate additional performance while at the same time lowering your overall risk.
Now that we have formed our strategic approach for investing the $400,000 for John and Jane, I will focus on the breakdown of the portfolio structure and holdings. Before I get started on the portfolio holdings, it is worth making a quick note about the current performance of the three major asset classes of shares, property and cash. Last calendar year the ASX 200 increased 14.60% (not including dividends), property prices of the eight Australian capital cities dropped -0.4% with an average rental yield of 4.2% for houses and 4.9% for units*, and the cash rate is now 3.0%. Many investors have been underweight in equities and overweight other assets for a long time as an aftereffect of the GFC. However, it is important to remember that diversification and having a balance across asset classes will help smooth out your returns over the long run.
* Data as per RP Data-Rismark December Hedonic Daily Home Value Index Results, released 2 January 2013
The Buy-Write Portfolio consists of a portfolio of stock and index call options. The ASX 200 index call options are sold over the top of the portfolio to generate income and lower risk.
For the options to lower risk (while generating income) the portfolio must have a high correlation to the ASX 200 index; without a high correlation the options will add risk. For an individual client it does not make sense to get this correlation by holding every stock in the top 200, as this would generate large brokerage costs while some holdings will be so small that it wouldn’t make it worthwhile. This issue could be overcome by purchasing a top 200 managed fund or ETF; however, there are three obvious problems in doing this.
First, the management fees would impact the returns.
Second, if you use a managed fund you would be buying into their existing tax obligations.
Lastly, not all funds or ETFs pass on the full benefit of dividends and the franking credits, which are vital for SMSF investors.
To overcome these issues and to ensure there is a high correlation, the Bellmont Buy-Write Portfolio matches the sector weightings of the ASX 200. For example, if the financial sector represents 39% of the ASX 200 Index then the portfolio will hold 39% of its stocks within the financial sector. Once the weighting is in place we then hand pick the stocks within that sector that we wish to hold. While we are limited to the sector weightings of the ASX 200, we still have the ability to stock pick within that sector and hold the best companies within each area of the market. Currently we have 22 stocks that make up our portfolio holdings.
Beta and Alpha
It is worth considering the Buy-Write Portfolio as part of an investor’s overall investment portfolio and how it impacts beta and alpha.
Beta is the measure of volatility between an investment and the underlying market; that is, how the investment performs when the market moves up and down. A beta of 1 indicates that the investment will move in line with the market. A beta of less than 1 means the investment will be less volatile than the market, for example if the beta of a portfolio is 0.5 then if market moves up 2% the portfolio is likely to only be up 1% and vice-versa: if the market is down 2% then the portfolio will be down only 1%. A beta of greater than 1 indicates the investment will be more volatile than the market. For example if the beta of a portfolio is 1.3 and the market moves up 2% then the portfolio is likely up 2.6% and vice-versa: if the market is down 2% the portfolio is likely to be down 2.6%.
Alpha is a measure of performance compared to the risk-reward profile of the investment. For example an alpha of 2.0 would mean the investment has outperformed its benchmark by 2%, and vice-versa an alpha of -2.0 would indicate an underperformance of 2% against its benchmark. For managers to generate positive alpha they usually have to take on more risk. An investor will look to add positive alpha (outperformance) to their portfolio, but will limit their exposure due to the added risk.
During the construction of the equities component of an investment portfolio many financial advisors and investors will look to balance their holdings between a portfolio, fund, LIC or an ETF that provides them with beta while then adding smaller components of alpha through more targeted strategies.
The nature of the Buy-Write Portfolio means that as an investor or advisor you will be obtaining beta, because the portfolio has a very high correlation to the ASX 200 while the option provides alpha and this is achieved with lower risk (volatility) than a standard managed fund, ETF or LIC that is used for obtaining beta. For John and Jane Brown, given they are in their late 50s and are not searching for large growth, the Buy-Write Portfolio will sit nicely with their overall investments as it will provide them with beta and alpha at lower risk.
You can read previous editions here.