With interest rates having soared over the past 18 months, the income environment has greatly improved for investors even though the path to getting there was sometimes rough. One of the popular strategies for really kickstarting your income stream is covered call writing. Kevin Simpson, Founder of Capital Wealth Planning and manages a pair of covered call ETFs, sees opportunities and challenges in the space today and joins the ETF Think Tank to give his thoughts on the current landscape.
Simpson’s strategies are built around high-quality companies rather than broad indexes. He simply targets companies that generate EBITDA and distribute cash flow to shareholders. While valuations and fundamentals are important considerations, Simpson believes that if you own companies like this over the long-term, the compounding effect will do wonderfully. Above all else, he primarily focuses on companies that are profitable and pay dividends.
Simpson’s company began developing a track record back in 2007 through separately managed accounts. He notes that he happened to hit at the right time in 2008 because they were able to buy inexpensive insurance before it was necessary. He lost 13-14%, but that was great, relatively speaking. In 2016, DIVO was launched, but it was a long, hard road to success. Most ETFs don’t become successful until year 3 and Simpson says that his company started to hit somewhere between years 3 and 5. It’s a grind with a lot of work.
Regarding Simpson’s covered call strategies specifically, they closely monitor their positions on daily basis and prefer out-of-the-money calls where expiration is around 30 days. Generally, he starts with calls that are 5% out-of-the-money. However, when the VIX barely generates a heartbeat and option premiums are low, he may be more cautious about entering positions because writing calls on stocks that are down 15-20% could screw them up with even a modest bounce. Simpson may try to write a 12% OTM call in a situation like that and the premium may still be good because volume is probably high. He looks at it as tactical covered call writing.
Dividend stocks have been out of favor, but has the Fed put them back in the spotlight? Simpson argues that there’s a recency bias, but dividend investing tends to work over time. People might pay up for growth, but dividends tend to work. The disparity between the performance of dividend payers vs. non-dividend payers hasn’t been this large since 2009.
Other key takeaways:
- Simpson starts by focusing solely on the S&P 100. Since he’s looking at dividend growth, the potential universe boils down to 75-100 names, of which 25-30 will make it in the ETF portfolios.
- What is the advantage to an SMA over an ETF? An SMA costs very little operationally. Institutions and family offices still think there’s something special about them having an SMA. SMAs allow for some customization.
- Not all dividend cuts are bad (e.g., Disney), but they are most of the time. Simpson generally avoids the risk and stays away from them.
- Until the tech improves, Simpson doesn’t see direct indexing really taking off. We had a 0% interest rate environment, and it was awesome, but the need for direct indexing is less in a normal world as it was during the previous low-rate environment. It’ll be more challenging to generate tax losses to harvest than it is with ETFs.
- Stocks with higher volatility generally present better covered call opportunities and vice versa. Tech generally makes for a better opportunity, but a lot of them don’t pay dividends so they’re not within their scope.
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