Tag: UMAX

Covered Call ETFs on the ASX

Global X has recently issued three covered call ETFs on the ASX:

  • S&P/ASX 200 Covered Call ETF (AYLD)
  • S&P 500 Covered Call ETF (UYLD)
  • Nasdaq 100 Covered Call ETF (QYLD)

The US has for a long time been spoilt with choice when it comes to ETFs and especially income-focused ETFs. To appreciate how much choice Americans have on covered call ETFs, you only need to look at the Global X US website to see they provide 12 different covered call ETFs to Americans:

What is a covered call ETF?

A covered call ETF uses a “covered call” strategy which involves the fund manager not only holding stocks and collecting dividends but also making additional income by selling call options against those stocks. The catch is that the call option gives the buyer the right to buy the stock from the fund manager if it goes up in value. This effectively means that the upside growth of a covered call ETF is curtailed because stock price increases allow the buyer of the call option to take the stock away from the fund manager. On the other hand, the covered call ETFs in theory provide downside protection because, if the stock prices goes down, the buyer of the call option cannot buy the stock and the fund manager pockets the income from selling the call option.

Betashares already provides covered call ETFs

Although Global X has recently issued AYLD, UYLD, and QYLD on the ASX, Australia’s own Betashares has already had covered call ETFs listed on the ASX. YMAX, which is a covered call ETF that invests in the top 20 Australian companies, has been around since 2012 whereas UMAX, which is an S&P500 covered call ETF, has been around since 2014. Betashares recently issued QMAX, which is a Nasdaq 100 covered call ETF, was recently issued in October 2022.

Something that definitely jumps out about covered call ETFs from Betashares is their high management fees. YMAX as a MER of 0.69%, UMAX’s MER is 0.79%, and QMAX’s MER is 0.68%. However, all of Global X’s ETFs have a MER of 0.60% making them slightly cheaper.

Betashares ETF, MERGlobal X ETF, MER
Australian equity covered call ETFYMAX, 0.69%AYLD, 0.60%
S&P 500 covered call ETFUMAX, 0.79%UYLD, 0.60%
Nasdaq 100 covered call ETFQMAX, 0.68%QYLD, 0.60%

Given that YMAX and UMAX has had such a long track record, we can look at their performance over time.

As the chart above shows, YMAX (in blue) has been on a steady decline since it was issued in 2012 whereas UMAX has been increasing. In fact, one seems to be a mirror image of the other, with UMAX rising about 30% since inception whereas YMAX has declined about 30% which means that if you invested half in YMAX and half in YMAX, you’d effectively be holding cash.

Of course, investors do not invest in covered call ETFs for price alone. They are focused on dividends. According to Market Index, YMAX has a dividend yield of 8.92% so far whereas UMAX has a dividend yield of 7.18% which means if you invest half in YMAX and half in UMAX, you’d effectively be invested in cash but in a high interest savings account that pays about 8% with franking credits.

It is curious why YMAX has underperformed UMAX so substantially, but I suspect the explanation comes from the volatility of investing in the top 20 ASX stocks. Because investing in only 20 stocks on the ASX means much of the money is concentrated in Australia’s miners and big bankers, this increases volatility compared to the broader, more diversified and more stable S&P500. As such, to compensate for the higher volatility, the buyer of the call option will pay less, which results in a lower options premium for the fund manager who is the issuer of the call option.

This volatility explanation for why YMAX underperforms UMAX can also be seen in covered call ETFs on the US markets. For example, QYLD, Global X’s Nasdaq 100 covered call ETF QYLD (of which there is a Reddit community called r/qyldgang), has underperformed XYLD, which is Global X’s S&P 500 covered call ETF.

In the chart above, QYLD (in blue) has underperformed XYLD (in orange) over a long period of time. Whereas the top companies in Australia are dominated by bankers and miners, in the US the top companies are dominated by tech firms such as Google, Apple, Microsoft, and Amazon. Given that the Nasdaq 100 index is concentrated mostly in tech and internet companies, there is more volatility, which may mean lower options premiums for the fund manager, which results in under-performance.

However, a quick Google search shows that the dividend yield of QYLD is about 11% compared to 7% for XYLD. This is also analogous to YMAX vs UMAX where YMAX underperformed YMAX on price but made up for it with higher dividend yield.

Buying multiple covered call ETFs to balance income and price

What this suggests is that blending different covered call ETFs can be used as a strategy during early retirement to draw down income but also preserving capital so that you do not run out of money. For example, if you retire at 50 with $2 million in net worth, you may wish to put it all in an Australian equity or Nasdaq 100 covered call ETF because you don’t have long to live but you have a lot of net worth, so you can afford some capital depletion. However, if you retire at 35 with $750k and want to live overseas in developing countries, you may wish to put it all into S&P500 covered call ETFs which hopefully will provide more capital preservation at the expense of lower dividend yield. If you retire at 45 with $1 million, it may be a blend of all S&P500, Nasdaq 100, or ASX covered call ETFs e.g. half in YMAX and half in UMAX. You can mix and blend to balance capital preservation and dividend yield.

Selling off high growth investments (such as crypto or property) during retirement and putting it into covered call ETFs is an alternative approach rather than selling off 3% or 4% at a time. When selling off assets, for many people there is psychological stress that they may run out of money. Putting everything in high dividend ETFs (including covered call ETFs) is a much simpler way to generate income for retirement.

Disclosure: Image made using Stable Diffusion. I hold YMAX and UMAX.

Living off Dividends vs the Four Percent Rule – Part 2

According to Wikipedia, financial independence is defined as “the status of having enough income to pay for one’s reasonable living expenses for the rest of one’s life without having to rely on formal employment.”

Financial independence does not mean you have e.g. a late-model luxury car, an expensive house, a nice watch, or even a paid-off house. If you have to work, you’re not financially independent because you are dependent on your job.

So how do you live off your investments forever? There are two main ways to achieve this: (1) live off dividends and (2) sell assets according to the “four percent rule.”

In a post I made back in 2018 titled 4% Safe Withdrawal Rate vs Living off Dividends, I claim that it is better to live off dividends because it is easier:

 [It] is better in my opinion to simply live off your investment income (dividends, rent, interest, etc) as there is no calculation involved and no work. Everything is on autopilot. That being said when living off dividends there is a trade off between income and growth (see The Problem with HVST) and this is where I think the four percent rule can be used as a guide. If your dividend income is more than 4% of your net worth, invest more in growth assets whereas if your dividend income is less than 4% of your net worth, invest in income-producing assets.

Living off dividends is indeed simple. Suppose you have $1 million. You invest it in a high dividend ETF (e.g. IHD, SYI or VHY) and that is it. The dividends will be paid to your bank account, which you live off.

However, there are many problems with relying on dividends. Typically Australian investors have relied on blue chip Australian stocks for dividends because of favourable tax treatment (due to franking credits). The problem is that these stocks tend to be concentrated among a handful of companies and historically Australian high dividend payers have performed poorly. It makes sense that high dividend paying stocks underperform because each dollar paid out in dividends is a dollar not reinvested in the company. Because the company pays out the profit as dividends, it is not able to use that money to further grow the company. The chart below demonstrates the underperformance of high dividend paying stocks by comparing an Australian high dividend ETF (black) with the broader Australian equity market (orange). For the sake of comparison, the Nasdaq 100 is represented in blue, which is the NDQ ETF tracking an index that consists mostly of technology companies that historically pay low dividends but instead reinvest profits for growth. Major companies in NDQ are Amazon, Microsoft, Apple, Google, Facebook, etc.

High dividend ETF IHD (in black) underperforms the broader Australian stock market (represented by STW in orange) and significantly underperforms the tech-heavy Nasdaq 100 index (represented by NDQ in blue). Source: Bloomberg

In contrast to the simplicity of dividends, implementing the four percent rule is more difficult, but there is considerable evidence that this approach is better, not only due to it being more tax efficient but also because the assets you invest in tend to earn more (as demonstrated in the above chart comparing the Nasdaq 100 ETF vs an Australian high dividend index ETF). Suppose you have $1 million. Rather than invest this in high dividend stocks or ETFs, you invest it in high growth stocks or ETFs that focus more on capital gains rather than dividends. You can choose NDQ, a Nasdaq 100 ETF, but if you want more diversification across countries and sectors, a good high growth ETF is VDHG, which invests in 90% global equities and 10% bonds. (Another ETF similar to VDHG but with slightly lower fees is DHHF.)

How to implement the 4% rule

When you retire, rather than rely on dividends, you simply sell off 4% of the value of the investments each year, so if you have $1 million you sell off $40k and then live off that for the first year. The expectation is that after you sell $40k then you will have $960k, but if we assume 7% annual growth then the next year your net worth will grow to $1.027 million and then you withdraw 4% of this, which is $41,088. This higher withdrawal in the next year accounts for inflation. (Note there is some uncertainty about whether, in this example of retiring with $1 million, you simply withdraw $40k each year or if you withdraw 4% of the new balance each year. I believe the latter option is safer because it explicitly accounts for inflation.)

The “four percent rule” is controversial with many arguing that it is only designed to last you thirty years. However, a simple fix to this problem is to withdraw 3% of your portfolio each year rather than 4% and, in my opinion, anything below 3% is far too conservative. Based on FireCalc.com, although the 4% rule fails with 95% probability after 30 years, the 3% rule is highly likely to last you forever. Basically if you are retiring in your 60s or 70s, you should be able to get away with the 4% rule, but if you retire any earlier, you should use the 3% rule instead.

The chart below made using FireCalc.com provides a simulation of historic stock market returns using the 4% rule and shows that over 70 years there is a good change you will not run out of money after 70 years but there is approximately a 10% probaility that you will (represented by lines going down below the horizontal red line).

Simulation showing the 4% withdrawal rate has an approximately 10% probability of failure over 70 years. Source: FireCalc.com

However, using the 3% rule, there are no probability where you lose your money (based on historic stock market performance), even under the assumption that you retire in your 30s and live for 70 years.

Simulation showing a 3% withdrawl rate being highly likely to last you forever. Source: FireCalc.com

The reason why selling off assets is more tax efficient is because capital gains are not realised until you sell the assets, which means you can sell them when you retire. By selling off assets when you retire, you do so when your income is low, which exposes more of your capital gains to low (or zero) income tax brackets. However, dividends are taxed once they are paid, which means that while you are working and accumulating assets, you’ll pay taxes on dividend income while your income is relatively high.

Capital gains are subject to Australian income tax rates once the capital gains are realised.

What will I do?

Early in my journey towards financial independence, I focused mainly on accumulating high dividend ETFs e.g. IHD and even HVST (see The Problem with HVST). When investing in purely Australian equities, I discovered that not only did my investments underperform but I also needed to pay taxes every year. To address this problem, I used a margin loan to borrow against my ETFs and diversify into international and emerging market equities more (e.g. I made some good bets on technology ETFs). Having a margin loan has its pros and cons, but one of the pros is that the interest on the margin loan is tax deductible, which helps to offset the tax paid on the dividends from Australian equities. Today Australian equities make up approximately half of my equities with the other half in international equities and a small amount of emerging market equities. Although I have a margin loan, I have started dabbling in NAB Equity Builder. NAB EB allows you to borrow at a lower rate compared to a margin loan.

While I am moving towards growth rather than dividends, I am still holding onto my high dividend ETFs. My plan is, rather than choose between dividends or growth, I will simply aim for both. There are many benefits of dividend investing e.g. franking credits. Furhermore, even though Australian high dividend stocks have underperformed in the last decade, there may be hope in the future as these companies enter the post-COVID future. If I sell Australian dividend stocks and use the proceeds to purchase global tech stocks, there is a very real risk that I will sell low and buy high, so rather than sell, I prefer to simply leave my Australian dividend stocks and ETFs. It should also be noted that there are other ETFs on the ASX that pay high dividends but do not invest in Australian equities e.g. UMAX uses options against the S&P500 to generate income; EBND invests in emerging market bonds and pays approximately 5% monthly; and TECH focuses on global tech stocks that have strong moats, and surprisingly this ETF has a dividend yield of approximately 9% paid yearly. I will discuss these non-Australian high-yield ETFs in a separate future blog post.

Property vs shares

Although it is clear that I have a bias towards shares over property, the strategy of selling down high growth ETFs exposes yet another benefit of shares vs property, which is the ability of ETFs to be sold in small chunks. If you have a $1 million property, you cannot sell half of it because no one will want half a property. You must sell it all in one go. Suppose you make $500k capital gains. Then $18200 of that will be exempt from tax while the rest of it is subject to tax, so you’ve managed to avoid tax on $18200. Now suppose you have $1 million in ETFs, which we will assume is $1 million all in VDHG. Rather then being forced to sell all of it in one go, you sell half of it in one year and the other half the next year. By doing this you realise $250k in each year. This exposes $36400 to the tax free threshold. By being able to sell smaller portions, you make the most of the tax free threshold.

Thanks to ETFs being highly divisible, I can sell off small amounts of ETFs each year thereby spreading capital gains across multiple years and exposing more capital gains to low tax brackets. Furthermore, any capital gains on assets held over one year receive a 50% CGT discount.

Another benefit of investing in ETFs rather than property is that you can sell ETFs cheaply e.g. selling one property will cost you about $20k to $30k in real estate agent commissions, but with ETFs you will pay about $20 or $30 to sell (or even $9.50 for discount online broker SelfWealth).

Other benefits of ETFs vs property is you avoid stamp duty and land tax. You also have access to franking credits.

Of course, in all fairness, there are some downsides of ETFs vs property e.g. the interest rate on NAB EB and margin loans are higher than those on mortgages, and although you can achieve leverage of about 70% using NAB EB or margin loans, you are able to achieve leverage of 80% up to 95% with property. In my opinion, even if you are able to achieve more leverage against property, it doesn’t necessarily mean you should. Leverage can magnify gains but also magnifies losses should the market go through a downturn. When leveraging into ETFs, you are able to diversify within the portfolio defensive assets such as bond ETFs (e.g. VDCO), hybrid ETFs (e.g. HBRD) or even gold mining ETFs (e.g. GDX), which reduces volatility. When you leverage into a property, you are all in one property in one place, exposed to an universified asset in one location. Many believe that property is safe compared to the volatility of the stock market, but if you invest in a highly diversified ETF, it is safer than investing in one property. The lack of volatility in property is actually the result of poor price discovery mechanisms rather than because property is inherently safer than shares. Once property is listed and exposed to the same price discovery mechanism of shares, property is highly volatile as evidenced by the price charts of residential REITs.

Disclosure: I own IHD, SYI, HVST, NDQ, UMAX, EBND, TECH, HBRD, and GDX.