The High Yield Equity Strategy helps investors achieve three major goals
The practice of capturing income opportunities with traditional dividend investing has stood the test of time. In multi-asset allocation, equity income strategies are an important source of income and provide opportunities for capital appreciation. While this is still true in today's market environment, the market is more volatile than ever before, and we are seeing an increasing need for clients to balance multiple investment objectives, including:
1) Seek higher yields,
2) capture potential capital appreciation,
3) Reduce risk. We believe a combination of dividend-paying stocks and the sale of call options1 can help meet today's urgent but challenging needs.
Goal 1: Seek higher yields
While traditional dividends are at the heart of all equity yield strategies, non-traditional methods, such as selling call options outside of a portfolio, can help generate additional income. By selling a call option1 (i.e. abandoning part of the potential capital appreciation), the potential capital appreciation can be converted into a continuous income stream. In addition, during times of high market volatility, it may be noted that the premium may be higher as a gain.
As shown in Figure 1, the additional income received in the form of option premium can help improve the return profile of the portfolio and hedge downside risk when market volatility increases, balancing the total return of the portfolio while reducing volatility relative to the broader market.
Figure 1: Premium as additional income
Source: Bloomberg, J.P. Morgan Asset Management, data as of the end of October 2023, the payout ratio is the 12-month dividend yield of the MSCI Asia Pacific ex-Japan index. Receive the premium by selling 30% MSCI Asia Pacific ex Japan Index options with 40% delta. For illustrative purposes only. The sale of the call option may forego some of the capital appreciation. Projected revenue is not guaranteed and does not represent a positive return. Past performance is not a reliable indicator of current and future results. The Index does not include fees or operating expenses and is not an actual investment.
The above portfolio allocations are hypothetical in nature and are for illustrative purposes only. Hypothetical portfolio allocations are intended to represent different risk/return profiles only and are not representative of actual asset allocations
Objective 2: Capture potential capital appreciation
The pursuit of higher yields does not necessarily mean giving up all the upside potential of the equity market, especially in the Asian market. Investing in a portfolio of dividend-paying stocks while selling call options (about 30% of the portfolio) is a hybrid strategy that helps to strike a balance between income generation and capital appreciation.
The option premium helps to make up for part of the income stream, making the stock selection process more flexible. In addition to high-dividend companies, you can also invest in stocks with higher growth but lower yields for potential capital appreciation. By selling a call option for 30% of the portfolio, investors can retain 70% of their Asian equity exposure to capture potential upside over the long term2.
From a regional allocation perspective, the Asia-Pacific region is the region that equity income investors should be looking at. Over the past 15 years, the average payout ratio for APAC companies has been 3.7%, which is higher than the average payout ratio for US companies of 1.9%, resulting in higher returns for income seekers3. In addition, the Asia Pacific region includes both emerging and developed markets, making the investment landscape more diverse.
Goal 3: Reduce risk
The rapid rate hikes by major overseas central banks such as the Federal Reserve since 2022 have prompted yield-seeking investors to turn to fixed income assets for higher yields, resulting in an accumulation of too much duration risk in portfolios. Fixed income assets, including investment grade and non-investment grade bonds, are sensitive to credit risk.
We believe that a stock return strategy that combines long and short options in equities can provide investors with a different risk profile and avoid the duration risk and credit risk that are commonly associated with bonds.