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From The No-Load Fund Investor, 6/17...
An Active Environment
The stock market remained strong in May. Led by large-cap growth stocks, especially in the technology sector, the S&P 500 pushed ahead by 1.2% and is up 7.7% so far in 2017, pre-dividends. Many international equity markets performed even better. The MSCI EAFE Index of stocks from foreign developed markets gained 3.1% in May and 12.2% year-to-date during the first five months of the year, again pre-dividends. Meanwhile, the international equity funds we track have roared ahead by 15.6%, on average. This suggests that a majority of actively managed international stock funds are beating the MSCI EAFE so far this year.
A funny thing has been happening too on the way to oblivion for actively managed U.S. stock funds over the past 12 months — about half of those we cover have beaten the supposedly unbeatable S&P 500. In fact, on average, the diversified U.S. equity funds we track have gained 16.9% over the past 12 months, vs. 15.0% for the index, pre-dividends, suggesting a virtual tie after dividends are included.
On average, actively managed U.S. stock funds have smaller median market capitalizations and more direct exposure to foreign stocks than does the S&P 500, which is all U.S. Therefore, as the Russell 2000 Index of small U.S. companies performed well in the second half of last year, while most international markets have performed well so far in 2017, the universe of actively managed funds has finally experienced an attractive operating environment versus passive investing. Now, if we could ever experience an environment in which small U.S. stocks and foreign equities outperform at the same time, active would have an excellent chance of beating passive (i.e., index) management.
It is difficult to find attractive income these days from investments with good risk-return profiles. While high-quality bonds are unlikely to default, or even suffer credit downgrades, they have puny yields. Meanwhile, though funds and ETFs for high-yield corporate bonds generally offer a little more than 5%, their yields relative to those of U.S. Treasures of similar maturities (so-called yield spreads) are well below average. This hurts their potential for strong total return (yield plus price change) over the foreseeable future.
Therefore, it makes sense to look for yield in other places—not overseas, necessarily, because yields are not attractive in most places outside the U.S., either—but rather in slightly more sophisticated investment strategies.
In particular, various options strategies may make sense for some investors who desire income from their portfolios. There are wrinkles with various options, but here’s generally how they work:
They come in two forms: Calls and Puts. A call option gives its owner the right, but not the obligation, to buy a certain security (most often a stock or stock ETF) at a certain price (called the strike price) on a certain date (called the expiration date). A put option gives its owner the right, but not the obligation, to sell a certain security at a certain price on a certain date.
Unfortunately, most people use call options like the lottery: they put down a little money on a bet that the price of a stock will be higher than the option’s strike price at expiration. If they’re right, they can buy the stock at the strike price, sell it at the higher market price and pocket the difference. Or, if the stock rallies beyond the strike price before the expiration of the option, the price of the call itself rallies exponentially, and its holder can make double, triple or even more on his or her money. With a put, the buyer can make a killing if the price of the underlying security falls well below the strike price.
However, if the price of the stock is below the strike price of the call at expiration, the call will expire worthless—its holder loses all he or she invested. In the case of a put, if the price of the underlying security is above the strike price at expiration, the put will expire worthless, and again the owner ends up with nothing.
In fact, most buyers of calls and puts end up losing all or most of their money on most of their options trades, for two reasons. One, some of the options end up worthless upon expiration. Two, even those that don’t end up worthless lose their ‘time value’ as the days pass toward expiration. With options, time is the buyer’s enemy, since the options waste away as there is less time for a stock to rally (in the case of a call) or decline (in the case of a put).
Our full analysis of listed ETF options can be found in the June issue of The No-Load Fund Investor.
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