Warren Buffett had this to say about them in his 2002 letter to shareholders:

However, in the same letter he later said this:

Buffett’s Options Strategy

What kind of ‘large-scale derivates transactions’ does Warren engage in?

While many investors buy options to speculate on what the price of a stock will do, Buffett typically sells options contracts.

A bullish view on the world’s markets

Between 2004 and 2007, Buffett sold a total of $4.5 billion worth of put options on the S&P 500, Britain's FTSE 100, the EuroStoxx 50, and Japan's Nikkei 225 indices.
He sold an additional $400 million worth of puts in 2008, putting the total premium received at $4.9 billion.

These were very long-dated put options, expiring between 2019 and 2027.

If you’re not familiar with put options, they give the buyer the right to sell a stock at a certain price. Investors buy them as insurance on their portfolios.

By selling the put options, Buffett was essentially betting that the world’s stock markets would go up between 2004 and 2019 - a pretty safe bet, considering that even though there’s often a reason to sell , markets tend to go up in the long-run.

Selling puts on Coke

In 1993, Buffett sold 50,000 put options (equivalent of 5 million shares) with a strike price of $35 for $1.50 per share on Coca-Cola.

Coke shares were trading around $39 at the time.

Let’s look at what Buffett was doing.

Buffett wanted to buy Coke shares, but wasn’t willing to buy them at $39.

Always patient, Buffett was waiting for the shares to come down in price. By selling the put options, he collected a total of $7.5 million in premiums.

He also guaranteed the buyers of the puts that he’d buy Coke at $35 per share.

If Coca-Cola shares stayed above $35, Buffett kept the $7.5 million.

If the price fell to $35, Buffett was effectively buying Coca-Cola for $33.50 per share ($35 – $1.50).

Either way, Warren won. He either kept $7.5 million, or bought the shares he wanted at the price he wanted to pay.

Again, a relatively safe strategy.

Which brings us to an ETF idea - a way to implement a safe options strategy.

Covered Call ETFs

We’ve written about covered call ETFs before.

If you’re not familiar with them, I’d recommend you read the article.

But if you’re not going to here’s a summary:

Covered call ETFs sell call options on owned stocks or indexes to generate income and reduce volatility, but cap potential gains.

A call option lets buyers purchase stock at a set price within a time frame, with sellers keeping the premium.

• How They Work: Sell call options for premium income, paid as monthly distributions, limiting stock upside

• Dividend Fluctuations: Distributions vary (30-50% yearly) with market volatility

• Capped Upside: Underperform in strong bull markets due to limited gains

• Fees: Higher expense ratios (0.35%-0.61%) than index funds like SPY (0.09%)

Trade-offs: High yields and stability come with volatile payouts, and weaker performance in rising markets.

Let’s look at a few options.

SPYI and XYLU

These ETFs aren’t identical, but they’re close.

• SPYI is available to American investors

• XYLU is available to European investors

SPYI - The NEOS S&P 500 High Income ETF

This fund seeks high monthly income in a tax efficient manner, with the potential for upside appreciation in rising markets. SPYI may also buy calls on occasion.

XYLU - The Global X S&P 500 Covered Call UCITS ETF

Follows a synthetic strategy to replicate a buy-write index by selling covered calls, with underlying equity exposure designed to match constituents of the S&P 500 Index.

Why these funds are similar

• Both funds are based on the S&P 500

• Both aim to produce high income levels

• Both funds write calls on a lot of their holdings

  • SPYI writes calls on 75%-90% of the holdings

  • XYLU writes call on 100% of the holdings

Advantages and disadvantages

The advantage of these funds is high income, that’s managed to be more stable from month to month.
The disadvantage is that they don’t capture as much of their holdings price appreciation.

JEPI and JEPG

These ETFs are both run by J.P. Morgan and are very similar

• JEPI is available to American investors and writes calls on the S&P 500

• JEPG is available to European investors and writes calls on the MSCI World Index

JEPI - The JPMorgan Equity Premium Income ETF

This is an actively managed ETF. It invests in a “defensive portfolio of large cap stocks”. It’s all about creating income and reducing volatility.

In addition to the portfolio of equities, JEPI uses equity-linked notes (ELNs) to create income similar to writing covered calls. Here’s how they work:

• combines a bond with an investment tied to the performance of a stock or index - in this case, the S&P 500

• You get your initial investment back at maturity (like a bond), plus a return based on how the linked equity performs, often with some protection or capped gains

Here are the top 10 holdings

JEPG - The JPM Global Equity Premium Income Active UCITS ETF

This is also an active ETF, and it uses the same strategy as JEPI - buying a conservative selection of large-cap stocks and using Equity-Linked Notes to generate a premium. JEPG uses the MSCI World Index for the ELNs.

Here are the top 10 holdings of JEPG

Advantages and disadvantages

The main advantage of these funds is a high income level and lower volatility - meaning they won’t fall as far in a market drawdown.
The main disadvantage is that the income from month to month is inconsistent, and that the lower volatility comes with less potential upside in a rising market.

GPIX

This is Goldman Sachs’ direct competitor to JEPI. Unfortunately, I couldn’t find a version available to Europeans. If you know of one, let me know!

GPIX - The Goldman Sachs S&P 500 Premium Income ETF

This is another active fund. It buys the equities underlying the S&P 500, then sells calls on the index. It’s managed to keep the monthly distributions more stable.

GPIX has a few interesting twists compared to JEPI:

• GPIX sells options on 25% to 75% of the portfolio

  • This means they can be more conservative or aggressive

  • Less calls written = less premium, but more capital gains upside in rising market

• Options are sold on the index, not the stocks

  • Index options can’t be assigned early

  • Makes them easier to ‘roll’ up or down - allowing more flexible management of the options portion of the strategy

• If the market gets really ugly, GPIX can sell all its positions and buy short term treasuries

  • I’d guess this is very unlikely to happen, but it’s interesting

  • I take it as another indication that the fund managers are trying to give themselves as much flexibility as possible

Advantages and disadvantages

The main advantages of GPIX are the flexibility, and ability to position to capture more price appreciation of the S&P 500.

The main disadvantages are that you’ll have less options premium coming in and that you’ll also capture more of the downside in a falling market.

A note on yields

Many of these ETFs list different yield numbers. They can be inaccurate because of the way they’re calculated.

• SEC Yield - doesn’t include option premiums

• Dividend yield / distribution rate calculation: uses the most recent payment/NAV for most recent dividend date

  • This can lead to artificially high or low yields because the distribution rates vary month to month

Pay attention to the 12-month distribution yield - probably the most accurate due to using a longer time frame

• This is calculated by taking the total distributions over the last 12 months and dividing it by the average NAV during the same time frame

Summary

These ETFs are worth considering.

They create a lot of income, and can add stability to a portfolio. But they also cap the potential for price appreciation and dividend growth.

Here’s how I think about each group:

• SPYI and XYLU: Create a lot of (relatively stable) income, but cap upside price appreciation

• JEPI and JEPG: Create a lot of income that isn’t stable month to month, and minimize volatility - these funds tend to fall the least, but also tend to rise the least

• GPIX: Is the most flexible fund - it will have lower income levels than the others, but will also likely capture the most market upside

The chart below shows the total return for the three American ETFs.

• JEPI is the least volatile, but also the lowest total return

• GPIX has the highest total return, but the most volatility

• SPYI is between the two in both total return and volatility

Updating the ETF Portfolio

Since we added our shareholder yield ETFs, we’ve been Dollar Cost Averaging into the three existing ETFs in the portfolio.

You can see the updated spreadsheet here:

Read more

We have ETFs full of Dividend Growers with dividend yields that are higher than the market average.

Today we’re adding an ETF to cover our third bucket of Cannibal Stocks.

Cannibal Stocks

“Pay close attention to the cannibals – the businesses that are eating themselves by buying back their stock.” - Charlie Munger

Cannibal stocks are companies that buy back a lot of their own shares.

Why does this matter?

Because buybacks increase your ownership of the company

If you own a business that earns $10 per share and the company buys back 50% of its outstanding shares, EPS will increase from $10 to $20.

The chart below shows how different levels of buybacks affect returns:

In addition to generating attractive returns, buybacks address one of the common criticisms of dividends - taxes.

The image shows the cumulative returns of different factors, net of taxes.

Shareholder Yield

Buybacks aren’t the only way for companies to return capital to shareholders.

Management teams can return capital through:

• Dividends

• Share buybacks

• Debt paydown

These three added together are called “shareholder yield”.

Shareholder yield performs even better than dividends alone!

Now that you understand the benefit of looking at more than just dividends as a way for companies to return capital to us, let’s add some cannibals to our portfolios!

Read more

That’s the entire philosophy of passive investing.

Let’s dive in and announce the second ETF for the Portfolio.

The essence of passive investing

Passive investors aim to match the market's performance instead of trying to beat it.

To build wealth you don’t have to beat the market, just follow these simple steps:

1. Spend less than you earn.

2. Invest at least 10% of your income in stocks every month.

If every family did this from the time they started working until retirement, most would become millionaires.

Compounding is truly powerful.

So, the sooner you start, the better!

How Does It Work?

1. ETFs: An ETF (Exchange-Traded Fund) is a collection of different stocks or investments you can buy and sell on the stock market, just like a single stock.

2. Buy and Hold: You buy shares of good ETFs and keep them for a long time. As the market grows, your investment grows too.

The Best Part?

Everyone can do it.

You don’t need to be interested in investing or spend a lot of time researching stocks.

Why Does Passive Investing Work?

1. Lower Costs: Passive investments have low fees because you’re not paying a manager to try to pick stocks. This means more of your money stays invested.

2. Less Stress: Since you’re not constantly checking the market or trying to make quick trades, it’s less stressful. You just set it and forget it!

3. Market Growth: The stock market has ups and downs, but tends to go up over the long run. By investing passively, you benefit from its overall growth.

4. Diversification: When you invest in an ETF, you own a small part of many companies. This spreads out your risk. If one company does poorly, it won’t hurt you as much because you have a lot of other investments.

In Short

Passive investing is simpler, costs less, and can lead to good returns over time if you’re patient!

Diversification

Diversification is an important part of passive investing.

By spreading your money across many different investments, you can reduce risk and boost returns.

By owning a little bit of everything, poor performers don’t hurt your returns too much.

You also increase your chances of gaining from the best-performing assets.

Diversification doesn’t just mean owing a lot of different companies.

It means owing companies in different places.

Global Diversification

As Peter Bernstein points out, you can’t predict where the next winner will come from.

Since the bottom of the Global Financial Crisis in March of 2009, US stocks have compounded at about 15% per year.

They have outperformed almost every asset over this period.

It feels like US stocks will keep going up forever.

So, why not just invest in U.S. ETFs?

Because US stocks don’t always outperform.

The chart below compares the performance of the MSCI USA index to the MSCI World index.

When the ratio goes up, it means U.S. stocks are doing better than the rest of the world.

When it goes down, it means U.S. stocks are lagging behind the global market.

This ratio can’t keep growing forever.

If it did, U.S. stocks would eventually make up 100% of global stocks.

Here’s another view, with U.S. stocks shown in red and global stocks in black.

Another great thing about buying stocks outside the US?

They’re cheaper.

Here are the PE ratios of different countries.

The US is the most expensive market.

The cheaper you buy stocks, the better your returns will be.

Remember this: lower stock prices are GOOD for you as an investor.

It always feels good to see your investments go up.

That’s why you should learn to feel excited when stock prices go down.

Still not sure? Think of stocks like hamburgers.

Here’s what Warren Buffett says about it:

Now let’s diversify globally by buying our Second ETF.

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Welcome to this week’s 🔒 exclusive edition 🔒 of Compounding Dividends. Each week we talk about the financial markets and give an update on our Portfolio.

In case you missed it:

1. How to Analyze a Dividend Stock

2. 750 Interesting Dividend Stocks

3. Rewatch Our Webinar

Subscribe to get access to these posts, and every post.

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Let’s be honest with each other.

More than 95% of investors underperform the market.

The main reasons?

• Trading too much (costs harm your return)

• Trying to time the market

• Making emotional investment decisions

• Lack of patience

• …

This study by JP Morgan found that the average investor earned an annual return of 3.6%, while the S&P 500 returned 9.5% over 20 years.

That's a difference of 5.9%!

We truly believe that some investors can do better than the market, but most would do better if they invested passively.

Everyone should invest

The beautiful thing about investing passively? Everyone can do it.

And everyone should.

Investing in stocks is the best way to create wealth in the long term.

If you invest $250 monthly for 40 years you’ll be a millionaire (assumption: return of 9%/year).

This number should be adjusted for inflation but you get the point.

While in the short term it’s risky to invest in stocks, it’s risky to not invest in stocks in the long term.

When you invest for at least 10 years, you have a 97% chance of making money:

If you don’t want to spend too much time on researching stocks, ETFs are a great option.

It allows you to invest while only spending 10 minutes a month.

Do you want to secure your financial future? Or do you know someone who does?

This ETF portfolio can really help.

How the portfolio will work

Each month, we will buy an ETF for $500.

For both the ETF portfolio and the individual stock portfolio, purchases will happen the day after the article is published.

Why?

I want to give loyal readers like you a chance to act first.

Partners of Compounding Dividends will always be able to make their trades before I do, after doing their own research.

The ETF we’ll buy tomorrow

• Has an attractive dividend yield of 3.4%

• Has grown its dividend by over 10% per year

• Has a 5-year earnings growth rate of 9.7%.

Here’s what $10,000 invested for 20-years looks like with those numbers:

Are you ready?

Let’s announce the first ETF we’ll buy within the ETF Portfolio.

Read more