Strategic Super Investor – Pt 3 of 3

posted on June 4th, 2013 by Bellmont Research Team

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The Strategic Super Investor has provided three professional SMSF advisors with different investor scenarios to manage for 12 months. In Summer, they allocated a portfolio according to the circumstances of their particular case. Autumn saw them meet clients for their first quarterly review. In this issue they track the portfolios for a six-monthly review, comment on performance and adjust if necessary…

Many investors make the mistake of jumping straight into stock selection without having a strategy for their portfolio.

John & Jane, like many SMSF investors, want to have exposure to the share market for capital appreciation and the yield generated with dividends and franking credits. This is especially the case with cash rates at 3% and the benefit of investing within a SMSF resulting in franking credits being rebated as cash.

The strategy I have selected for John & Jane is the Bellmont Buy-Write Portfolio as it provides exposure to capital appreciation of shares while having a steady income stream and more importantly smoother performance and lower volatility than the ASX 200, which is ideal for SMSF investors.

The past couple of months have seen the Bellmont Buy-Write Portfolio outperform for John and Jane as the ASX 200 has been unable to push past its February highs. In a consolidating market like we have seen we expect the buy-write portfolio to outperform the underlying ASX 200 index. In this editions article I will explain how John & Jane’s portfolio will perform in different market conditions.

Performance in Differing Market Conditions

The Bellmont 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 volatility. Let’s see how the use of the index option will alter the performance of the Bellmont Buy-Write Portfolio in different market conditions.

Rapidly Rising Market

In a market that is rapidly rising the Bellmont Buy-Write Portfolio will underperform the ASX 200 index. The reason for this is that the index option caps how high the portfolio can go for the duration of that option contract. Let’s look at a practical example.

ASX 200 value at the start of the month: 5000 Index option strike price: 5150 (3% above the current value of 5000) Income generated: 25 points (this equals $250 per contract sold, a yield of 0.5% on the current ASX value of 5000) Option Duration: 1 month ASX 200 Value at end of month: 5250

In this example the index option have capped the portfolio at 5150; in return for limiting the portfolios maximum growth to 5150 the option has generated an income of 0.50% for the month. The market has rallied 5% to 5250, the maximum return for the Bellmont Buy-Write Portfolio this month is 3.50% (3% upside which is then capped + 0.50% income from the option). In a rapidly rising market like this the Bellmont Buy-Write Portfolio will still do really well (3.50% return for one month!) but it will not do quite as well as the underlying market. For John & Jane Brown this is what we saw at the start of this year as the ASX 200 pushed rapidly higher to 5200. This is quite normal and what is expected if the market rallies sharply.

Steadily Rising Market

In a market that is steadily rising the Bellmont Buy-Write Portfolio will outperform the ASX 200 index. The reason for this is the income generated from the index option has provided additional performance. Let’s examine the same scenario as before.

ASX 200 value at start of month: 5000 Index option strike price: 5150 (3% above the current value of 5000) Income generated: 25 points (This equals $250 per contact sold, a yield of 0.50% on the current ASX value of 5000) Option Duration: 1 month ASX 200 value at end of month: 5100

In this example the market has rallied 2% for the month (from 5000 to 5100). The index option has enabled the portfolio to generate an additional income of 0.50% providing the Bellmont Buy-Write Portfolio a total return of 2.50% (2% market increase + 0.50% option income) compared to 2% for the ASX 200 index.

Flat Market

In a market that is flat the Bellmont Buy-Write Portfolio will again outperform the ASX 200 index, this is due to the income generated from the index option. Let’s examine the same scenario as before.

ASX 200 value at start of month: 5000 Index option strike price: 5150 (3% above the current value of 5000) Income generated: 25 points (This equals $250 per contact sold, a yield of 0.50% on the current ASX value of 5000) Option duration: 1 month ASX 200 value at end of month: 5015

In this example the market is flat having only moved up 0.03% for the month (from 5000 to 5015). For the Bellmont Buy-Write Portfolio, because we have generated an additional income of 0.50% for the month, the total return is 0.53% compared to 0.03% for the ASX200 index.

Falling Market

In a market that is falling the Bellmont Buy-Write Portfolio will once again outperform the ASX 200 index. The income generated from the index option acts as a cushion against a downward move. Let’s examine the same scenario as before.

ASX 200 value at start of month: 5000 Index option strike price: 5150 (3% above the current value of 5000) Income generated: 25points (This equals $250 per contact sold, a yield of 0.50% on the current ASX value of 5000) Option duration: 1 month ASX 200 value at end of month: 4900

In this example the market has dropped 2% for the month, falling from 5000 to 4900. For the Bellmont Buy-Write Portfolio, because we have generated an additional income of 0.50% for the month the portfolio has only fallen 1.50% compared to 2% for the ASX 200 index. In this scenario Bellmont Buy-Write Portfolio will still retrace in value, however the income from the option cushions the blow therefore reducing the volatility of the portfolio.

In all market conditions except a rapidly rising market, the Bellmont Buy-Write Portfolio will outperform. While it is impossible to accurately predict exactly where the market is going to go, with the Bellmont Buy-Write Portfolio you are able to put the probabilities of outperformance in your favor and at the same time lower your volatility while picking up dividends and franking credits.

For many SMSF investors being able to lower their volatility and having a smoother return is ideal. This is exactly the reason why we have recommended this strategy for the $400,000 that John & Jane Brown have allocated to Australian equities in their SMSF.

This article is part three in a four part series. To read the part one please click here.



 

You can read previous editions here.



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