A recent Gallup Poll shows that “For the first time this decade, a majority of non-retired Americans, 52% doubt they will have enough money to live on comfortably once they retire”.¹

 

The Wall Street Journal also reports that investors are no longer interested in paying financial advisers to watch their portfolios go down the drain. There is a “seismic change in the market” says Will Hepburn, president of the National Association of Active Investment managers who was quoted in a recent Journal article. 2

 

This begs the question “How can I convert my portfolio of stocks and mutual funds to one that is an income generating machine?” I believe there is a great opportunity ahead for the investor, advisor or planner who is familiar with covered call writing.

 

 

Let’s take a glance into the future of investing, and how it will look for retirees. For purposes of this exercise, I’d like to divide the retired into two philosophies; those being old fashioned, buy-and hold investors; and those investors we’ll classify as “new age” or income seeking investors.    

 

Retirees of the future know they’ll have to reduce needless expenses and somehow convert their portfolio of stocks and mutual funds into one that generates as much income as possible during retirement. After all, wasn’t that the idea from the very beginning?

 

They’re hoping for one last chance at a 100% market rally that will take their portfolios back to pre- bear market levels. Old fashioned investors are hoping to break-even as they begin taking mandatory withdraws from accounts that are the result of a lifetime spent scrimping and saving.  But well educated, “smart phone” wielding investors are as comfortable placing stock transactions
from a remote location as they are “texting” their kids at college. 52% of all wealthy investors polled admit to checking their bank and brokerage account balances using mobile technology. 3

Reducing Needless Portfolio Expenses

 

One way of accomplishing their retirement goals is for these investors to swap 100% of their equity and bond mutual fund holding for a similar Exchange Traded Fund. (ETF) ETFs are highly liquid securities with ultra-low management fees that can be 80% less than a typical mutual fund.

 

After a quick review of eight random bond funds from four different, yet popular mutual fund companies, we noticed that the funds charge between 45 and 110 basis points per year on their intermediate government bond funds. A similar yielding ETF, the Barclay’s 20 year Intermediate US Government Bond ETF (symbol: TLT) charges 15 basis points or 66% less in yearly management fees*. The TLT also distributes its dividends monthly benefiting those living on fixed income alone.  

Using a calculator purchased from a garage sale, (very old school) we determine that for every $500,000 of bond funds an old fashioned investor owns, they’ll pay a minimum of $2,250 per year or $56,250 in “phantom” management fees over the course of a 25- year retirement, while the ETF investor will pay $750.00 or $18,750 over their 25 year retirement holding exchange traded funds. What possible benefit is there to owning mutual funds over exchange traded funds at this point in the retirement game?  

 

 

However the main advantage in taking an new age approach to investing is the ability to sell call option premium on the ETFs now owned in the account. The main objection to using call options is that it caps off any upside potential in the security, but I predict they’ll forsake upside gains in exchange for reduced portfolio volatility and income generation.

 

The same theory applies for equity funds. If an investor owned $2,000,000 of the Fidelity Contra fund (symbol: FCNTX), they’ll hand over $18,800 per year ⁴, or $470,000 in mutual fund management fees over a 25 year retirement, while the ETF investor is going to liquidate their mutual funds and swap them for broad based exchange traded funds charging 85 basis points less.

 

Using a Black-Scholes pricing simulator we can determine that selling upside calls on the TLT will generate $10,800 in premium in the next 12 months for every $250,000 invested. This strategy calculates out to a 12.53% internal rate of return on a US government bond instrument normally yielding 3.91%. Compare this IROR against the outright ownership of similar, low-yielding US bond fund where investors will pay 35 to 93 bps more in yearly expenses.

 

 

The Chicago Board Options Exchange in cooperation with Ibbotson- Morningstar and Callan Associates have already laid the groundwork which proves that a systematic covered call, or
“Buy-Write” strategy produces 38% higher (risk adjusted) returns than a buy and hold approach.⁵

 

Those who ignore the benefits of applying a call option overlay on a diversified portfolio of equity, fixed, commodity and foreign currency ETFs for 76 million “baby-boomers” entering retirement, may be hitching their business to an endangered species known as the mutual fund industry.

For more information about our covered call writing overlay strategy click here.

 

 Endnotes

 

 

* Disclosure: Fidelity (FGOVX) charges 45 bps; which was at the very the low end of the range of the bond fund sampling. I have a majority of my personal investment accounts with Fidelity and like their customer service. I have no issue with Fidelity per se, but using their funds as examples for this exercise. Examples shown are not meant to be mathematically precise, but an accurate representation for designing a retirement planning concept.