Backtesting A Simple Trading Strategy For Covered Call Funds (2024)

A couple of months ago, I wrote about the Global X S&P 500 Covered Call ETF (XYLD). XYLD invests in the S&P 500 index, and sells covered calls on the entirety of its holdings. Effectively, the fund trades most of its upside potential for an increased 8.5% yield.

Although I thought, and said, that the fund might be a good fit for retirees and income investors, both the Nuveen S&P 500 Buy-Write Income Fund (BXMX) and the Nuveen S&P 500 Dynamic Overwrite Fund (SPXX) seemed better choices. BXMX and SPXX have similar, if not identical, strategies and NAV returns, but their discounts were quite large at the time. This meant higher distributions and the possibility of capital gains if discounts were to narrow.

Since then, discounts have narrowed, and both funds have performed quite well:

Due to the above, I thought it would be interesting to backtest a more thorough discount trading strategy employing these three funds. Basically, invest in the fund with the biggest discount.

Said strategy seems to work, and has moderately outperformed all funds since their inception.

Investors wishing to employ said strategy should consider an investment in XYLD, as neither of the CEFs offers competitive discounts.

Fund Selection Analysis

For this little exercise, I've decided to focus on three covered call funds: XYLD, BXMX, and SPXX.

I've decided on these three funds for three key reasons.

First, and most importantly, is the fact that all three funds have effectively identical strategies, invest in the S&P 500 index and sell covered calls on the same, and NAV returns.

The only significant difference between these three funds is their discount rates. As such, I expect discount rates to play a significant role in their (relative) performance. Funds with large discounts should outperform those with smaller discounts, as discounts tend to equalize, at least in the long term.

Second, is the fact that all three funds offer strong distributions.

Strong distributions are almost always a benefit for shareholders, and mean that these funds are more appropriate for retirees or income. Strong distributions should also benefit the trading strategy, as higher discounts boost these.

Third, is the fact that XYLD is an ETF, which means discounts and premiums are arbitraged away due to a redemption mechanism. This functions as an 'anchor' for the strategy: there will always be one fund with a 0% discount to trade around.

This is particularly important because discounts are pro-cyclical. Discounts are widest during downturns, which means the best time to buy CEFs is during downturns, but to buy you need to sell something, and selling a CEF during a downturn is a bad idea. Selling an ETF during a downturn, however, is, well, not the best idea either, but much better than selling a CEF, as you don't have to worry about widening discounts.

Strategy Explanation

I'll be backtesting a very simple strategy: buy the most discounted fund at the end of each month, assuming a 4% discount for XYLD. So, for example, if both BXMX and SPXX have a 3% discount, I would be investing in XYLD. I'm giving this small advantage to XYLD as the point of the strategy is to only invest in the CEFs when discounts are wide, and discounts smaller than 4% are not wide enough, in my opinion at least. The 4% figure was chosen as this is their average discount since inception.

Performance information was downloaded through Alpha Vantage, discount information taken from Seeking Alpha.

Strategy Results - Effective Strategy

The strategy seems to work, and it has outperformed all three funds since inception in late 2013 to May 2021. Results are as follows:

Source: Author

Importantly, performance seems to be driven by the strategy. Investing in discounted covered call funds work, as discounts tend to narrow, boosting returns.

Taking a closer look at just why and how the strategy worked might be of interest to readers, so let's do just that. A bit of context first.

A graph of the performance of the strategy and the funds since inception:

and a graph of fund discounts for the same:

With these two graphs in mind, we can say the following.

From late 2013 to mid-2016, the strategy said to invest in BXMX and SPXX. During this time period, investors benefited from stronger distributions due to fund discounts, and so saw marginally higher returns than average.

From mid-2016 to early 2017, the strategy said to keep investing in BXMX and SPXX. During this time period, discounts narrowed, and investors saw very strong capital gains.

From early 2017 to early 2020, the strategy said to invest in XYLD. During this time period, discounts were mostly flat, so performance was average. In early 2020 the coronavirus pandemic hit, and discounts widened by over 20% in a matter of weeks. The strategy said to invest in XYLD, and so avoided these losses. Today looks a lot like early 2017.

From early 2020 to about now, the strategy said to switch from XYLD to BXMX. Discounts have narrowed since, and investors saw some very strong capital gains.

Importantly, the strategy was effective in both minimizing losses during the downturn and maximising gains during the recovery, a strong combination.

As mentioned previously, the fact that XYLD is an ETF and so does not experience significant discounts or premiums was key. No discounts meant XYLD suffered significantly fewer losses during early 2020, and allowed investors to buy into BXMX at rock-bottom prices without selling stocks at a discount.

Conclusion

A strategy of investing in BXMX and SPXX when discounts are wide, but in XYLD when discounts are narrow, would have delivered strong market-beating shareholder returns for the past eight years. Taking into consideration the strong similarities between these three funds, and the results from the backtest, I believe that the strategy will remain effective in the future. At current discounts, the strategy says to invest in XYLD, but barely so.

I think investors holding these funds, or similar covered call funds, should consider implementing a discount trading strategy like the one described above. I think it works, I think it should lead to strong returns in the coming years, and the fact that XYLD is an ETF means investors don't even have to worry about widening discounts during downturns, at least if the strategy is effectively implemented. It's just a win-win strategy, in my opinion at least.

Finally, do consider implementing similar strategies for CEFs and ETFs in other asset classes. Remember, ETFs never trade with significant discounts, so a strategy of investing in ETFs until discounts widen, then switching to a CEF, should work for a lot of different asset classes.