The Complexity and Risks of Covered Cap Funds

In the final portion of this week’s marathon discussion of the use of options in a personal portfolio, I’m going to describe the risks associated with using covered cap funds in your portfolio to generate yield.

Specific to a Covered Cap ETF is the risk of unexpected appreciation. This may seem counter-intuitive, as unexpectedly large gains in an asset we own is usually considered to be an exciting benefit to owning the stock. However, a Covered Cap fund sells calls under the assumption that their sophisticated risk models have correctly anticipated the near-term fluctuations of the underlying asset. If the stock rises beyond the predictions of their risk models, the fund will be forced to sell the underlying assets to the buyer of the contract, and will thus lose the ability to profit from additional growth in the stock.

This may sound trivial, as the fund has still generated an absolute return through the generate premium, it results in a greater volatility in the NAV of the fund, as it is continually fluctuating. It also increases the risk of contango (discussed in a previous article), as the performance of the fund it greatly tied to the performance of the underlying assets of the derivatives. The end result? An unexpected appreciation in the value of the underlying assets may result in a large sell-off in the stock, as investors cash out of the fund and buy the underlying assets themselves, in anticipation of the execution of the call options, and the continued growth of the underlying assets, which in turn causes additional unexpected growth in the assets, causing a greater opportunity loss for the fund.

Another risk specific to a Covered Cap fund is the risks associated with the liquidity of the derivatives being sold. As options become more popular, the volume of derivatives being sold increases, thus causing the value of the premium to fall. This supply glut causes the yield of the fund to decrease, which will likely cause the value of the fund to decrease as well, as disappointed investors sell off their holdings. As discrepancies between the volatility of the underlying asset and the assumptions behind the options sold become more apparent (profitable), more investors and funds will sell call options until the discrepancy is corrected.

So how do we mitigate these risks? Firstly, we consider them to be only a single part of an already diversified portfolio. With the help of an investment advisor, we can build Covered Cap funds into a small pocket of our portfolio that is reserved for complex income-generating assets. From there, we can also focus on funds that deal mainly with highly liquid industries. The market for options in these industries and companies are robust enough to accommodate an increased volume of sellers without greatly impacting the yield of the fund itself. While this reduces the absolute yield of the fund itself, it secures the yield, resulting in a more reliable income.

Remember, we don’t want to be greedy for returns, we want to be greedy for consistency. Lastly, an investor can cycle into and out-of Covered Cap funds based on overall market conditions. If a specific industry is expected to trade flat for a given period, consider entering it through a Covered Cap strategy to get some yield out of it. If the market is expected to greatly increase in value over the short term, consider leaving Covered Cap strategies alone, and simply involving yourself with the underlying assets directly. Lastly, if the industry is expected to decline over the long term, consider holding onto your positions for the rest of the month, and then selling off to avoid the decreasing value of held positions themselves.

Remember, there’s lots of information here to think about when dealing with sophisticated positions. You can always count on your investment advisor to help you when dealing with this level of complexity.