Markets may be in turmoil, but Eden Rahim believes his covered-call strategy will weather the storms and yield a steady income.
"This is a more defensive strategy, because you are willing to exchange the low probability that the market will rise, say 5% or 6% a month, for the high probability that it won't do that," says Rahim, lead manager of the $176-million Horizons Enhanced Income Equity ETF HEX and vice-president of Toronto-based Horizons Investment Management Inc.
"Your decision, as an investor, says, 'I'm willing to give away the upside for those one or two months when the market has an extreme bull (period), in exchange for 10-11 months it doesn't do that, and I'll collect the option premium.' That's the trade-off."
In his argument for using covered calls, Rahim points out that over the past 65 years, the market produced a monthly gain in excess of 5% in one out of every eight months. "Most of those months were clustered together when they emerged into a new bull market," says Rahim, noting that the most recent example is the doubling of the S&P 500 from March 2009 to April 2011.
There were similar powerful rallies following bear markets in 2003, 1982 and 1976. "This strategy will underperform in those bull markets," admits Rahim. "But when you transition into more 'normal' markets that are choppy and correcting, this is when our strategy adds value. This is what we are going through right now."
Introduced last March, the fund is one of four covered-call ETFs that are designed to make gains in weaker markets. "If the rate of ascent is slow and gradual, that's nirvana for us," says Rahim. "Investors will get the net asset value, and also collect the option premiums."
Rahim strives for nirvana as a money manager by writing out-of-the-money one-month call options on the 30 largest Canadian stocks by market capitalization. All of them are held in equal weights. (An option is out of the money when the strike price -- the price at which the option can be exercised -- is higher than the current market price.)
Each stock in the ETF has an implied volatility which is used to determine the call option on a future price at a future date. For instance, based on a $54 strike price for Barrick Gold Inc. ABX, Rahim will sell the call option for a premium of 50 cents, or 1% of Barrick's net asset value of $50.
Because each stock's implied volatility is different, the degree to which Rahim's option holding is out of the money will vary. For instance, the option on moderately volatile Barrick may be 8% out of the money, but that of the highly volatile Research In Motion Ltd. RIM will be 20% out of the money. Taken together, the 30 stocks in the ETF provide a premium of slightly more than 1% per month of net asset value, or 12% a year.
The ETF's net asset value will follow the market, and can't avoid negative returns in tough markets. Indeed, the fund lost 12.5% for the six months ended Oct. 31, compared with a 12.3% median loss for the Canadian Equity category.
"But you are exchanging one benefit for another," says Rahim. Although the total potential upside is limited by the option call, investors will collect the option premiums as income. "If the market is rising 3% to 4% a month, you are getting that gain, plus the premium."
A native of Trinidad, Rahim is a 25-year industry veteran who had an unconventional start. He attended the University of Toronto, graduating in 1986 with a bachelor of science in molecular genetics. "But I traded my way through university, mostly by shorting gold stocks," he recalls. "My father ran a jewellery manufacturing business in Toronto. I got the investing bug watching the fluctuations in gold and silver prices."
Rahim landed a job as a business analyst at Canadian Depository for Securities Ltd., where he stayed for seven years. In the meantime, he refined his trading expertise and in 1991 placed first in a stock-picking competition.
In 1993, Rahim joined Royal Bank Investment Management Inc., where, among other tasks he was a biotech-sector manager for five years. He also began writing covered calls for about $3 billion in assets.
In 2004, Rahim left the bank to form Taliesin Capital Inc. and manage the Taliesin Multi-Strategy Hedge Fund. In mid-2010, he began working as a sub-advisor to JovInvestment Management Inc., which provided advisory services to Horizons. He joined Horizons in October 2010 and began planning the covered-call ETFs.
While investors can write covered calls on their own, he argues that they cannot tap into the options market with the same degree of efficiency as Horizons. Moreover, "we can write options premiums and distribute the premiums each month, at a low cost."
Meanwhile, Rahim argues that investors will benefit further if volatility continues to be high. "When volatility goes up, the option-premium value goes up. So we are writing higher option premiums. In this 'debacle' of a market, our yields have gone up anywhere from 20% to almost 100% in some cases."
