Mispriced equity options: a potential source of income

It was very, very important for us to not have an undifferentiated strategy in the marketplace. We wanted to come out with something that was really, truly different than everything else out in the marketplace.

And really one of the things we’re doing that’s different than most of our peers is we’re writing calls on individual names. By writing calls on individual names versus writing calls on the index, you actually earn more income. Number two, we’re not taking any counterparty risk unlike some of our competitors. We earn – we receive income from our call premiums day one when we sell the calls.

From a process standpoint, we have six different portfolio managers working together on TCAL. Four of those portfolio managers, like myself, are fundamental portfolio managers, and two are quantitative portfolio managers. The fundamental portfolio managers are really tasked with identifying the best risk-adjusted opportunities in this lower-risk bucket of equities.

The quantitative portfolio managers are identifying the names with the most attractive yields, but also the most attractive quantitative characteristics. We marry those two insights together into a portfolio of 60 or 70 underlying equities and write calls on those names, generally, monthly.

TCAL is a strategy that owns 60 to 70 high- quality, low-volatility stocks and then writes single-name call options against each one of those holdings. The strategy's goal is to provide clients with a consistently high, single-digit yield; strong downside protection; and exceptional risk-adjusted returns over time.

TCAL can be utilized by investors in a variety of ways to help pursue their financial objectives. First, TCAL can serve as a stand-alone investment for clients seeking a high level of income with reduced market exposure and low interest rate or duration risk. But TCAL can also be combined with a traditional portfolio of stocks and bonds in an effort to enhance risk-adjusted returns and diversify income. So how does that work?

In a traditional balanced strategy, there are two main sources of income: dividends on the equity and interest from the fixed income holdings. By adding covered calls to a balanced portfolio, an investor is selling future volatility, or upside, in their underlying equity holdings. In exchange, an investor receives payment in the form of a call premium. Those call premiums, whose value is driven by underlying equity volatility, represent a third source of income in a portfolio that just holds stocks and bonds.

The addition of covered calls also gives investors the ability to dynamically alter allocations in their portfolio based on the prevailing market conditions. Investors can examine the level of dividends, Treasury rates, credit spreads, and equity volatility and then allocate their portfolio in a manner that reaches their desired level of yield relative to their risk tolerance.

We have been utilizing covered calls in the capital appreciation suite for more than a decade to enhance our risk-adjusted returns and to tactically alter portfolio weightings as market conditions change. We're excited to make this element of our investment process broadly available to clients in an ETF.