For investors who are open to a little extra risk, there are two refreshing ways to top off their portfolio’s yield.
When I think of the apex of customization, my mind is immediately drawn to 7-Eleven, which became the first major retailer to offer self-serve fountain drinks in 1983. Up until that point, a customer ordered their soda, and someone behind the counter would fill it. But that glorious day in the early ‘80s marked the birth of the Graveyard—also known as the Suicide in some states—a mixture created just for the customer, with whatever mix of carbonated beverage they liked.
Similar to beverage customization, investment customization has come a long way. Security selection is perhaps the best-known advantage of a customized separately managed account (SMA). Investors may be less familiar with the ways they can tailor their portfolios for yield enhancement. Let’s take a look at two key approaches.
How can investors use factors to enhance yield?
Using equities to customize for yield enhancement isn’t a completely new invention. Investors have had access to a variety of dividend-focused strategies for years. One specific way to get access to yield enhancement is to use a dividend factor strategy. Factor investing is an investment approach that involves targeting quantifiable firm characteristics, or factors, that can explain differences in stock returns. A few other popular factors besides dividend yield include momentum, value, and quality. A factor-based investment strategy involves tilting equity portfolios toward and away from specific factors in an attempt to generate long-term investment returns in excess of benchmarks. The approach is quantitative and based on observable data, such as stock prices and financial information, rather than on opinion or speculation.
This type of strategy is ideal for investors with a long-term focus and a willingness to accept higher risk in pursuit of higher excess return potential due to the factor risk premium. When used on a standalone basis, our research estimates the predicted tracking error of a factor strategy to be between 3% and 6%. Many investors blend factor strategies with a broad-based cap-weighted benchmark in order to bring that relative risk down. A factor-based strategy is also suitable for investors who want to replicate the risk characteristics of an active portfolio without paying active management fees.
Building portfolios that attempt to maximize the investor’s exposure to a specific factor may bring along bets that certain investors might not be aware of. Focusing on dividend yield exclusively will tend to build portfolios that overweight certain dividend-paying stocks in financials, industrials, and energy. This is why some factor-based strategies provide investors with the ability to maximize certain factor exposures while still constraining the unintended exposures that come from that type of investing.
How can investors use options to enhance yield?
Another way to capture yield enhancement in a customized portfolio is through the use of options. Using options to enhance the return on the portfolio’s underlying assets has been an often-used strategy since listed options started trading in 1973, a decade before customized beverage pouring came into vogue. An investor who buys options is essentially buying insurance. Most people who buy homeowners’ or auto insurance take it for granted that the insurance company includes a profit margin, or risk premium, into the price of the insurance. We see a similar dynamic in the options market: Option buyers are willing to slightly overpay, which offers option sellers the potential for collecting a risk premium.
Put selling is often used in conjunction with a client’s fixed income assets or cash to enhance return. When selling a put option on an equity index, the investor receives an upfront premium. If the index is down moderately, flat, or up, the put option will expire worthless and the profit to the investor is the upfront premium. If the index is down significantly, the investor may need to repurchase the put option at a loss. Again, some options may end up being unprofitable, but if done systematically over time, the investor will tend to collect a risk premium, which serves to enhance the return on their fixed income portfolio.
The goal of incorporating these strategies into an investment portfolio is to potentially enhance return while at the same time keeping risk under control. It’s possible to customize a call-writing program to correspond to the characteristics of the investor’s underlying equity portfolio. For clients who happen to have a large concentrated equity position, a managed call-writing program may be able to enhance returns and minimize the risk of having shares called away. Investors can also use put-selling programs to enhance returns on a bond portfolio or cash, with parameters of the programs set to be consistent with the investor’s risk-return profile. Programs can be offered as option overlays, so the investor doesn’t have to make changes to their underlying portfolio. For those who want a packaged solution, an option program can be combined with fully customizable underlying beta.
The bottom line
Yield enhancement through factor investing and option strategies can offer investors the opportunity to adjust their portfolios to meet their specific criteria. Since no two investors are alike, achieving these goals can look different for each of them. But the ability to create the right mix to meet every investor’s individual needs is something we can all agree tastes right.