Absorbing Volatility through Covered Calls
Crossmark Steward Covered Call Income Fund
Author: Ticker Magazine
Last Update: Apr 23, 12:17 PM EDT
|Markets are inherently volatile, but the right mix of options can certainly mitigate volatility. Paul Townsen, portfolio manager of the Crossmark Steward Covered Call Income Fund, explains how by giving up some upside for a covered call, investors can replace a volatile return pattern with more stable returns.
ďA covered call mutual fund mitigates the volatility events from a risk standpoint. With this type of strategy, you need a full market cycle to get its inherent benefits.Ē
Q: Would you give us an overview of the fund?
Crossmark Global Investments, founded in 1987, is an independent investment advisor headquartered in Houston, Texas. The firm serves retail and institutional investors across the country.
Crossmark Steward Covered Call Income Fund was launched on December 15, 2017. It is part of the Steward family of funds, which includes Steward Large-Cap Enhanced Index Fund, Steward Small and Mid Cap Enhanced Index Fund, Steward International Enhanced Index Fund, Steward Select Bond Fund and Steward Global Equity Income Fund.
A key feature of all Steward Funds is the values-based screening methodology, which allows investors to avoid businesses that contradict their values. The Steward screens exclude companies involved with alcohol, tobacco, gambling and mature content. In that space, we have a lot of traction with the millennials and the rapidly growing number of investors, who seek competitive returns without compromising personal convictions, values or social issue basis.
The fund provides income potential and limited capital appreciation. Although it is only 60 days old, we have already seen different ways in which the fund can perform. It may lag when the markets are going up, but when volatility comes back, the Covered Call fund will outperform.
Q: What is the size of the fund and the company?
Crossmark has about $5 billion in assets under management. That includes the Steward family of funds with about $1.5 billion in assets under management, our institutional index-based business, and the separately managed accounts through several partners. Right now, the Covered Call fund is seeded with $25 million.
Q: What core beliefs guide your investment philosophy?
We believe that thereís a need for a covered call option on the market, especially for the investors who couldnít meet an SMA type minimum. Our covered call strategy received a lot of traction on the SMA side, so we decided that creating a covered call mutual fund, which applies the values-based screening methodology, would make a lot of sense.
The idea is to allow investors to access the return profile without compromising their personal convictions. The Steward screens, added to the mutual fund, have been a driver and a catalyst. In addition, covered call investors have been looking for yield. There has been the need for a fund that provides not only limited capital appreciation but also enhanced income. Thatís the philosophy behind creating a covered call fund within the Steward Funds strategy.
Markets are inherently volatile and fragile, but there are times when we can protect our downside by coverage through options and other instruments. We have to give up some upside to have a covered call and the result is more sustainable returns instead of a volatile return pattern.
The fund is based on an index, so the value comes from the option overlay standpoint, which helps to offset losses over the course of a market cycle. For instance, in 2008 our SMA strategy was down 25%, compared to a decline of 36% in the S&P 500 Index. Last year, when the S&P 500 was up 21%, our SMA strategy was up 16%.
In other words, the strategy represents investing with shock absorbers. If the market goes up, the fund is going to lag because the upside is kept. But when the market goes down, we are going to outperform, because the sale of the covered call will offset some of the market losses. When the market is flat, we will get the income that we generate from the option overlay. That really helps from a performance standpoint.
Since 2008, the market has had an unprecedented nine-year run, so we expect a change from a volatility standpoint. Obviously, the asset allocation is structured to avoid being 100% long in 2008 or 100% in fixed income in 2013 or 2017. The fund is meant to complement a large-cap strategy, a fixed income strategy, or a global one.
Q: How do you incorporate your core beliefs into your investment process?
The fund is based on the S&P 100 Index and the Steward values-based screening methodology is applied on top of it. That structure in itself removes a lot of the risk.
We start with the S&P 100 index names and our screens remove 12 of those names. So we begin with a portfolio of 88 names and then we optimize it for risk control to the S&P 500 Index. The portfolio is inherently close to the S&P 500 in terms of sector diversification but we are buying the S&P 100 and then adding the Steward values-based screens.
The next step is the option overlay. Our holding period of a stock is tied to whatever option we sell. The option overlay involves a lot of technical analysis focused on price momentum, term structure, earnings, dividend date, where we get the most premium in the term structure, and where we want to sell that option.
Since the fund is based on an index, we already know what the 88 names are going to be. The names are the easy part, but the big value-added is trying to be at least 90% covered at all times. We enhance the income by trying to cover up as much of the underlying basket of stocks as we can.
Our extensive experience and history with our SMA strategy has given us a lot of knowledge on the option overlay. The fund is similar to the SMA strategy, because it is market driven from a volatility standpoint, but we donít write LEAPS, or long-term equity anticipation securities. Instead, the options are staggered by design, based on the sector, the earnings and dividend payment dates.
Overall, the option overlay is the big catalyst behind the performance and the value added at the fund. Otherwise, it is an S&P 100 index fund.
Q: What other factors are involved in your process?
The most important factor is always going to be covered calls. Again, because we already know what our basket of stocks is, the value added is the option overlay. The analytics that go into building the option overlay portfolio are the key element, especially in terms of staggering the options based on sector, earnings announcements and dividend payments dates. Since this is an enhanced income product, we want to capture as many dividends as possible.
Itís a strategy that could be traded every day, if needed, because thereís so much volatility right now on the market. The fund is only 60 days old, so we are still adjusting the option overlay and how it is going to play in the long run, but thatís the concept for setting it up.
Q: Could you illustrate the process with some examples? What do you monitor daily?