Westwood Holdings Group’s Parag Sanghani thinks energy prices would probably stay the same. He co-manages two funds that you might want to look into if you agree and are searching for investments that yield significant levels of income.
Many funds pay monthly distributions, and many use option methods to increase income for their shareholders. To avoid having a large percentage of their portfolio committed to any one fund, investors who prefer this strategy and require the income may be well advised to look at a range of strategies and funds.
Twenty-three securities of American and Canadian corporations involved in the transportation, storage, and distribution of natural gas and oil are held by the Westwood Salient Enhanced Midstream Income exchange-traded fund (MDST).
The 22 equities in the S&P 500 energy sector are held by the Westwood Salient Enhanced Energy Income ETF (WEEI).
Dividends from the underlying stocks and premiums obtained through a covered-call trading method are used to fund the monthly payouts of both funds, which were founded in April. Since the beginning, the monthly payouts for both funds have been 23 cents per share. The money is actively managed.
The Westwood Salient Enhanced Midstream Income ETF’s annualized trailing dividend yield, based on the share’s closing price of $27.89 on Tuesday and its monthly payment of 23 cents, has been 9.9%.
Additionally, based on Tuesday’s closing price of $22.65 per share, the trailing distribution yield for the Westwood Salient Enhanced Energy Income ETF has been 12.18%.
Although the funds’ track records are brief, further details regarding their performance in comparison to other exchange-traded funds that track their benchmark indexes are provided below.
Reduced volatility and additional revenue—for a cost
To increase their monthly dividends, both Westwood energy funds engage in covered-call option trading. This reduces the possibility of a decline for shareholders and allows them to offer income returns that are close to or higher than 10%. The cost is that the funds forfeit a portion of the upside potential of the underlying companies.
A call option is an agreement that, until the option expires, permits an investor to purchase stock at a specific price (referred to as the strike price). In contrast, a put option gives the buyer the ability to sell a security at a predetermined price up until the option’s expiration.
An investor who already owns stock can write a covered-call option. Usually “out of the money,” the strike price is higher than the current price of the stock.
This is a basic illustration for a single stock: Assume you own 100 shares of a stock that is trading at $100 a share right now. Although you like the stock, you’re willing to sell it for $110. An investor who thinks the shares will trade significantly higher than $110 before the option expires buys a call option from you for a fee. You are compelled to sell the shares at that price if it rises above $110. You must now find another investment, but you keep your option fee. However, you retain your option premium and are free to write another call option if the stock doesn’t increase above $110 before the option expires.
A portfolio manager can generate a consistent flow of fee money by continuously writing covered-call options. Additionally, the manager may trade out of a covered-call option before it is exercised or allow the stock to be called away and then buy more shares if the price of the underlying stock is rising to the point where it looks likely to be called away. greater price volatility tends to result in greater option premiums.
Sanghani stated in an interview with MarketWatch that the two Westwood funds’ approach is to write covered-call options on the majority of their assets.
Funds use a variety of covered-call tactics. Here are three more instances:
— The managers of the Eaton Vance Enhanced Equity Income Fund II EOS often sell out of their option positions before they expire, and the fund owns about 50 equities and writes covered calls on each of them. In December, we interviewed the management of this 20-year-old fund.
Using equity-linked notes is an additional method of earning option premium income. The management of the JPMorgan Equity Premium Income ETF JEPI and the JPMorgan Nasdaq Premium Income Equity ETF JEPQ both use this tactic. The assets managed by the latter fund are $39 billion.
Depending on the amount of option premium income available, a fund manager may also decide to be more opportunistic and write covered calls on a small number of assets at a time. Kevin Simpson, co-manager of the Amplify CWP Enhanced Dividend Income ETF DIVO, employs this approach.
As part of the payouts, funds that employ covered-call methods may repay a portion of the investors’ initial investment. Funds may do this for a number of reasons, one of which is that price growth in a stock portfolio may offer “cover” to return some investor capital without significantly lowering the share price of the fund. Another is that even after an option has been exercised, resulting in a gain on the sale of a stock, a portfolio manager may “roll the option to the next month” to post a loss for an ETF due to structural tax advantages, according to Sanghani.
In the end, a fund’s return of money to investors lowers the cost basis of the investment instead of distributing taxable revenue. By doing this, some capital gains taxes are postponed until the investor sells their shares of the fund.
A broad covered-call strategy will increase investment income while reducing fund volatility. This indicates both weaker upside capture and lower downside capture as compared to an index. While your income increases, your risk decreases, but at the expense of part of the upward potential of an index or sector.
The argument in favor of the energy industry
Sanghani spoke extensively about the state of energy costs today. But first, let’s take a look at a 15-year chart that displays West Texas Crude oil prices for continuous front-month contracts:
The biggest change in the above table was the drop in crude prices from July 2014 to early 2016, excluding the market disruption during the early stages of the COVID-19 pandemic in 2020. The overabundance ultimately led to consolidation and even bankruptcies among U.S. oil companies.
According to Sanghani, the Organization of the Petroleum Exporting Countries’ role as the industry’s “pressure value” reduced the likelihood of another price drop, even if he still anticipated an ongoing oil excess. He responded, “That is exactly how we see it,” when asked if this indicated that OPEC had given up market share to producers in North America. Production has been reduced by roughly 4 million barrels per day by OPEC.
He went on: “OPEC’s ultimate goal is to profitably sell the oil they are producing. Additionally, they desire consistency and prices that are high enough to support their budgets.
The OPEC nations “tried to do a price war in 2015 and 2016, which I think they thought hurt themselves as much as it hurt North America,” Sanghani said.
He continued by saying that an oil price of $70 was “really healthy from a production and growth standpoint,” and that investors were experiencing less risk as a result of the capital-spending discipline of U.S. producers.
Volumes increased by 10% annually ten years ago. It is currently 3% annually. “OPEC has the confidence to maintain price stability because of this positive-feedback loop,” he said.
Thus far, performance
According to Sanghani, investors should generally anticipate “high single-digit returns” for the energy sector, which include dividend yields of roughly 3% and average annual price appreciation of roughly 6% for stocks of oil producers, midstream firms, and suppliers of associated services and equipment.
Thus, we examined the revenue side. In reference to call option premium prices for energy companies, he stated, “Volatility is priced very high in the options for this industry.”
We are unable to provide a thorough performance history because the Westwood Salient Enhanced Midstream Income ETF and the Westwood Salient Enhanced Energy Income ETF were only created a year ago. However, both funds’ goals of paying out large monthly payouts have been achieved.
The Alerian Midstream Energy Select Index serves as the benchmark index for the Westwood Salient Enhanced Midstream Income ETF. According to FactSet, the Alerian Energy Infrastructure ETF ENFR, which tracks the index, has a dividend yield of 4.27%.
The S&P 500 energy sector serves as the benchmark index for the Westwood Salient Enhanced Energy Income ETF. The Energy Select Sector SPDR ETF XLE, which has a dividend yield of 3.15%, tracks this index.
The performance of all four ETFs from April 30 to Tuesday, when dividends were reinvested, is shown here. For the Westwood Salient Enhanced Midstream Income ETF, returns are net of expenses, which amount to 0.80% of assets under management per year, while for the Westwood Salient Enhanced Energy Income ETF, they amount to 0.85%.
Since April 30, the Alerian Energy Infrastructure ETF has returned 34.7%, while the Westwood Salient Enhanced Midstream Income ETF has returned 22.2%. This illustrates how using the higher-income covered-call strategy results in less upside capture.
According to Sanghani, record production volumes of natural gas and oil in North America have helped midstream corporations, who are the distributors and operators of oil and gas pipelines. He stated that “in 2024, many companies were at or below leverage targets, allowing for free cash flow to be used for higher dividends and potentially more growth opportunities.”
According to him, the midstream stocks’ performance was a reflection of “a realization by the market that we’ll be using natural gas for a very long time,” and the expansion of data centers to accommodate generative artificial intelligence technology will increase the use of natural gas power plants.
