One of the reasons investors resort to risky behavior is because they either don’t have investment plans they can stick to, or if they have plans they don’t have the discipline to adhere to them. As Warren Buffett has noted, a main cause of the failure to earn market returns is “a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline).”

Take a step back now and think what would have happened if each of the 17 prior times the government shut down you bailed out of the market, incurring trading costs and, in taxable accounts, capital gains taxes. Do you think you would have benefited? How would you have known when to get back in?

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To begin, it’s important to acknowledge that the concerns are real and well-placed. While a short-term shutdown of the government likely will have a minor impact on the economy, as it has in the past, no one can accurately forecast the consequences of a default on our debt. As a good example of the impossibility of knowing the answer to that one, in hindsight is safe to assume that the Federal Reserve would not have allowed Lehman Brothers to fail in the way it did in 2008. That was the event that precipitated the seizing up of the capital markets. And a repeat, or worse, performance could result if we defaulted.

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A call option contract gives the holder the right, but not the obligation, to buy a security at a predetermined price (the strike price) on a specific date (European call) or during a specific period (American call). A call is “in the money” when the current price of the stock is trading above the strike price and “out of the money” when the reverse is true.

You make the call

Many investors buy call options as part of their investment strategy. Unfortunately, it’s likely they do so without knowing the returns to such a strategy. This is an all-too-common problem that isn’t limited to options trading — individuals don’t know the returns on their investments. For example, the authors of the study “Why Inexperienced Investors Do Not Learn: They Don’t Know Their Past Portfolio Performance” found that not only do individual investors dramatically overstate their performance, but performance is negatively related with the absolute difference between return estimates and realized returns.

In other words, the lower the returns, the worse investors were when judging their realized returns. They noted that while just 5 percent of investors believed they had experienced negative returns, the reality was that 25 percent did so!

With this in mind, Ryan McKeon, the author of the study “Returns from Trading Call Options,” analyzed the performance of a strategy of buying calls. He used the bid-offer spreads to take into account trading costs (though commissions and other fees were not considered). This is important not so much because the spread is wide, but because the spread can be wide compared to the price of the option. The following is a summary of his findings:

• Call option returns are generally low and decrease as the strike price increases.

• Deep in-the-money calls generally deliver positive returns if held for a month, while all other calls deliver returns that are negative or not statistically significant from zero.

• Deep out-of-the-money calls deliver lottery-like returns — very large losses on average, with occasional, but rare, large and positive returns. Of the 709 options that fell into this category, 706 expired worthless, with the average return being -91 percent. The three that did produce a profit provided returns of 1,092 percent, 2,414 percent and 2,600 percent. Such returns provide the hope that leads to mostly very poor results.

• The holding period didn’t matter.

These findings are consistent with studies that show that individuals are risk seekers in that they have a preference for investments that have lottery-like distributions (such as “penny stocks,” stocks in bankruptcy, IPOs and small growth stocks). They produce very poor results on average, but on rare occasions they provide outsized returns. The other explanation is that investors don’t realize how bad such strategies are in terms of expected returns. If you’ve been buying call options, you no longer have that excuse.

The poor results of a buying calls strategy raises the question about the results of the other side of the trade — selling calls and earning the premium. There are many investors who engage in this strategy by selling what is referred to as covered calls.

Covered Calls

A covered-call strategy requires the investor to write (sell) a call option on stocks that are in the portfolio. Essentially, the covered-call investor is trading off the upside potential (above the strike price) of the equity investment for an up-front fee and reduced (by the size of the call premium) exposure to downside risk.

Marketers of covered-call strategies demonstrate the efficiency of the strategy through the “Sharpe ratio,” a measure of the return earned above the rate of return on riskless short-term U.S. Treasury bills relative to the risk taken, with risk being measured by the standard deviation of returns. While the Sharpe ratio is a useful risk-reward measurement tool, it defines standard deviation as the measure of risk. While standard deviation does measure the volatility of returns, volatility is not the only measure of risk. Investors care not only about volatility, but also about other characteristics of the distribution of returns, such as skewness.

Skewness measures the asymmetry of a distribution. Negative skewness occurs when the values to the left of (less than) the mean are fewer but farther from the mean than are values to the right of the mean. For example, the return series of -30 percent, 5 percent, 10 percent, and 15 percent has a mean of 0 percent. There is only one return less than zero percent, and three higher; but the one that is negative is much further from zero than the positive ones. Positive skewness occurs when the values to the right of (more than) the mean are fewer but farther from the mean than are values to the left of the mean. As we have already mentioned, the evidence suggests that investors prefer assets with positive skewness, like the lottery ticket. They generally try to avoid assets with negative skewness.

This leads us to the question of what impact does a covered-call writing strategy have on the potential distribution of returns. Does it shift the distribution away from a normal one, rendering the use of measures such as the Sharpe ratio less meaningful? The study, “Covered Calls: A Lose/Lose Investment,” covering the nine-year period of February 1987 to December 1995, found that that while covered-call strategies did produce a lower standard deviation than did an indexing strategy, because the covered-call strategy eliminates the upside potential it produces negative skewness of returns (the kind investors dislike). For example, using a strategy of one-month covered calls produced a negative skewness of 4.6 versus a negative skewness of just 1.1 for a buy-and-hold indexing strategy. The negative skewness calls into question the relevance of the Sharpe ratio for this strategy.

Trim the fat

While it is true that a covered-call strategy does reduce kurtosis (“fat tails”), the problem is that it eliminates the potential for the good fat tail (the one to the right), while having no impact on the risk of the bad fat tail (the one to the left) occurring. Risk-averse investors would much prefer to eliminate the risk of the left fat tail (bear market) while accepting a smaller right fat tail (bull market).

Unfortunately, there are other negative features of covered-call writing strategies which include tax inefficiency and high transactions costs. As an alternative, I recommend investors consider lowering their equity allocation while increasing their exposure to small and value stocks.

Copyright © 2013, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

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Why Have Rates Increased?

In most developed countries such as the U.S., interest rates are heavily influenced by central bank policy. The Federal Reserve is the U.S.’s central bank. For several years, the Federal Reserve has pursued very “loose” monetary policy, meaning it has done everything within its means to keep interest rates as low as possible to aid in the recovery of the U.S. economy. On June 19, Federal Reserve Chairman Ben Bernanke indicated that the central bank might begin curtailing its loose monetary policy later this year and ending some portions of its policy next year. These indications about future plans are no doubt one reason that interest rates have been increasing.

Will Rates Continue to Go Up?

Of course, we believe it is virtually impossible to guess the direction of future rate movements. We can, however, say something about what might cause rates to increase further or to fall. Some reasons why rates might further increase:

• The economy performs better than expected.
• The market’s expectation for future inflation increases.
• The Federal Reserve tightens monetary policy more quickly than expected.

Conversely, rates would likely fall if the economy unexpectedly performed poorly, inflation expectations declined or the Federal Reserve decided to pursue loose monetary policy.

How Have Bond Investments Been Affected?

When interest rates go up, bond prices go down. Therefore, returns on bond investments can be negative during these periods. In general, though, short- and intermediate-term bond investments have not been severely affected. For example, the Barclays Capital Intermediate-Term Government Bond Index is down just 1.09 percent through June 20. Further, the Barclays Capital 5-Year Municipal Bond Index was down just 1.19 percent over this period. While no one enjoys negative returns, these are hardly sharp negative returns.

Keeping the Big Picture in Mind

For investors who have followed our general guidance to use short- and intermediate-term, high-quality bonds and bond funds, there is a positive side to higher interest rates. Higher interest rates mean the bond returns you expect to earn are higher now than they were previously. For investors with a long investment time horizon, this is a plus.

Investors must also keep a total portfolio perspective in mind. While interest rates have increased and some bond investments have experienced negative returns in 2013, the stock market is up with the S&P 500 Index up 12.5 percent through June 20. Because one of the key concepts behind diversification is having investments that move in opposite directions, this yet again shows the benefits of having a well-devised approach to building diversified portfolios.

Copyright © 2013, The BAM ALLIANCE. This document and all attachments are provided to you, our client, as a service of BAM Advisor Services, LLC. We hope you will use it to keep abreast of emerging research and investment trends, take advantage of up-to-date advice, and revisit the principles on which your investment advisory practice has been founded. Please be aware that this material is provided solely as background information for Registered Investment Advisor firms and is not approved sales or marketing literature. It should not be distributed to clients without prior approval of BAM. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

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When you interview potential advisors, you should look for the advisor who gives the best advice and is the best fit for you. The best advisors begin earning their fee from the day they are hired by helping you determine your most appropriate asset allocation, according to your unique ability, willingness and need to take risk. This is what we do with every single investor who becomes a client.

In determining your need to take risk, we will typically run retirement projections. This can be a particularly eye-opening experience if your portfolio is much more aggressive than needed.

However, many people believe all advisors using Dimensional Fund Advisor (DFA) funds (including those with very low fee schedules) will provide advice and service of equal quality. Investment advice is not a commodity. There is no free lunch. Hiring an investment advisor is an important decision, and all factors should be considered. We believe that high quality and high levels of service are typically accompanied by a fair price.

Examples of Bad Advice or Service

• Incorrect asset location — Academic evidence has shown that investors should locate their tax inefficient assets in tax-advantaged accounts. Many low-cost/low-service DFA providers use the same allocation for all accounts, regardless of whether they are taxable or tax-advantaged. This “model” structure is much easier for advisors to set up and maintain, but it costs you in taxes.
• Tax-loss harvesting — Many low-cost/low-service advisors will do tax-loss harvesting infrequently, if at all. Again, this makes portfolio management easier for the advisors but can cause you to pay more in taxes.
• Using too many funds — Advisors who slice asset classes too fine or use too many funds increase the costs of rebalancing. These costs do not show up in performance related marketing materials based on model portfolios, but they should not be ignored.
• Infrequent rebalancing — Low-cost/low-service advisors will often only check for rebalancing opportunities once per quarter, if even then. We use sensible tolerance ranges to determine when to bring the portfolio back to its intended risk/return profile.  

The Value of Good Advice

When selecting an advisor, fees are an important consideration. However, you should also consider the services offered for those fees. Some value-added benefits we provide include:

• Executing and maintaining a portfolio tailored to your needs that fits your ability, willingness and need to take risk
• Rebalancing when the portfolio has moved outside of its tolerance ranges
• Offering separate account management for fixed income portfolios where this makes sense
• Providing risk management expertise (including long-term care, life insurance and property and casualty insurance)
• Integrating your investment plan with your estate plan
• Providing Roth conversion strategies and Social Security claiming strategies
• Offering advice on mortgage refinancing

Making the Decision

When hiring an advisor, we strongly advise meeting the advisor in person. This is the best way to determine whether you can truly trust this person with your financial future. Many times, low-cost/low-service providers will only communicate via telephone and e-mail. Further, these advisors likely have 500 to 1,000 customers, making it nearly impossible for the advisor to have any type of personal relationship.

The key to making the decision is finding an advisor who you believe will give you the best advice and is the best fit for you. When making this decision, be sure to consider not only the fees advisors will charge but the services they will provide. While good advice doesn’t have to be expensive, bad advice almost always costs you dearly.

Copyright © 2013, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

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