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The Search for Income: Covered-Call Funds

Equity investors looking for added income may want to consider covered-call CEFs. 

Cara Esser, 06/08/2012

In the never-ending search for income, equity investors often boost income-generation potential by way of derivatives. In the context of fund investing, a popular strategy for equity closed-end funds, or CEFs, to boost income is to sell call options on the underlying portfolio. This strategy goes by many names (covered call, buy-write, and option overlay to name a few) and is wide-ranging in its implementation.

I often read Morningstar.com's CEF Discussion Boards to gain a sense of what is top of mind for our readers, and covered-call CEFs are often a hot, and divisive, topic. Some believe these funds are great at generating additional income on top of equity strategies that are often low-income-generating, while others think less highly of the strategy. And, as the CEF analyst covering these buy-write funds, I've received many questions about how they work and if they are right for an investor's portfolio. While I can't assert whether a specific fund is right for any investor's individual portfolio (those decisions are complex and should be considered on an individual basis), I can provide a primer on the ins and outs of these funds.

The Basics
Let's start from square one. Call options provide the buyer with the right--but not the obligation--to purchase a security at a specified price (strike price) at some point in the future (prior to the expiration date). For this option, the buyer pays the seller (or writer) a fee (option premium). In the context of a covered-call CEF, the fund is the call writer, or seller. Once a call option is written, the fund is obligated to sell the asset at the specified price should the buyer choose to exercise the option, or to buy back the call prior to it being exercised. In short, writing call options means the writer is selling some of the security's future upside potential to earn the option premium up-front.

Option premiums are priced based on implied volatility: If investors think the market will be highly volatile, an option will be priced higher. In times of extreme volatility, option prices can skyrocket, and covered-call CEFs can benefit from earning large option premiums. Historically, implied volatility has been higher than realized volatility, which means call writers have been generally overcompensated for the risks of writing call options. (On the flip side, this means that buyers have historically been overpaying for these options from a realized risk/reward perspective.)

Time to expiration and the "moniness" of the call option affect the premium as well. First, the longer the time to expiration, generally the higher the premium. "Moniness" refers to the relationship between the strike price and the underlying asset's market price. Options can be written in, out, or at the money. In-the-money options earn the highest premium because, assuming no option cost, they are exercisable immediately. Accounting for the option premium, the option won't be exercised until the difference in strike price and asset price exceeds the premium paid. Out-of-the-money calls are priced based on how far out of the money they are, with a higher premium being paid for a strike price that is closer to the asset's market price. At-the-money options are written with strike prices equal to the current asset price (these also won't be exercised until the difference between strike and exercise prices is greater than the premium). Most CEFs write calls that are at the money or slightly out of the money (typically 1% to 3%, but some write calls more than 5% out of the money) and most are short-term in nature (30-90 days, but shorter-term options are also used).

As an extremely simplified example of how a call option works, let's say a fund writes one call option on a single share of ABC stock for $10, expiring in 30 days. The stock is currently selling at $9, so the call option is 11% out of the money (11% being the increase that a $9 stock has to enjoy before hitting $10). The fund receives $0.10 in option premium because in this example the call option is worth only $0.10. The fund will keep any gains from share price appreciation from $9 to $10.10 (again, the buyer won't exercise the option unless it provides a gain over the price paid, which in this case, is $0.10), plus it keeps the call premium. Should the stock appreciate past $10.10 in 30 days, the fund misses out on any of those gains above $10.10. Because of this, in a quickly and steadily rising market, a fund writing call options will tend to underperform a similarly invested fund that does not write call options.

On the flip side, in a steadily declining market, the fund will pocket call premiums because options generally won't be exercised, but its underlying portfolio will be declining in value with the market. The call premiums help soften the blow, allowing the fund to outperform similarly invested funds in down markets.

Single Stock vs. Index Options
Of the 31 closed-end funds employing covered-call strategies (Morningstar categorize funds as "covered call" if they overwrite at least 50% of the portfolio's notional value), there is a good mix between those employing single stock and index strategies. Note that there are a number of funds employing a call-writing strategy on less than 50% of the portfolio.

The single stock strategy is used by less than half of covered-call CEFs. While the strategy is straightforward (funds write call options on individual stocks in the portfolio), the implementation varies across funds. Some funds write options on every single stock, some on just those where they find the options to be most profitable. The number of options written varies also, as some funds will overwrite the entire holding and others will overwrite just a portion.

BlackRock Investments is a proponent of the single stock option strategy and uses it on each of its covered-call funds. This preference is due to higher premiums that single stock call options generate compared with broad index options. Higher premiums allow the funds to overwrite less of the portfolio, leaving more potential for earnings from capital appreciation of the underlying holdings. All of BlackRock's covered-call funds generally overwrite 50% of the portfolio's notional value.

The index option strategy is also a simple concept: The fund writes call options on indexes that are representative of underlying holdings. A large-cap, domestic-equity fund, for example, would write call options on the S&P 500 Index or a representative exchange-traded fund. Again, the level of overwriting varies by fund as does the number of indexes on which the fund writes call options.

Eaton Vance is a proponent of index options, and six of its eight covered-call CEFs use this strategy. The firm prefers this strategy because the underlying stocks are left alone to appreciate as much as possible. Picking the stocks that will outperform or underperform and assigning call options based on this analysis can be difficult. Index options allow for the underlying portfolio to keep appreciating even as the call options are being exercised. Of course, the fund has to deliver the underlying index or the ETF when it is exercised, and shares may be sold in order to meet these demands. ‚Äč

Covered-Call CEFs: What to Look For
In the context of CEFs, investors should be aware of a few issues. First, lumping all covered-call CEFs into the same category for performance comparison is inappropriate. The funds' underlying portfolio strategies are extremely diverse. While most invest domestically (two thirds), a handful invests either globally or in foreign countries only, and two follow a more sector-specific strategy (Columbia Seligman Premium Technology STK invests in a concentrated portfolio of technology stocks, and GAMCO Natural Resources Gold & Income GNT focuses on gold and natural-resources firms). All of the funds hold equities but track different indexes (Nuveen Equity Premium Opportunity JSN holds a 75%/25% combination of the S&P 500 Index and the NASDAQ 100 Index, for example), some are dividend-focused ( BlackRock Enhanced Equity Dividend BDJ generally holds only dividend-paying stocks), and others are value-focused (NFJ Dividend Interest & Premium NFJ invests using a value-based screening process).

Second, the call strategy itself can be very different from fund to fund, as mentioned previously. It's important to understand how the call options are written (Eaton Vance, for example, generally prefers at-the-money and slightly out-of-the-money options while BlackRock generally prefers slightly out-of-the-money options). A number of the funds in the group also use put options in order to limit volatility (buying, selling, or both), which can change the expected return profile of a call-only fund.

Because of these differences, investment decisions should be made first on the underlying strategy (domestic versus global versus sector-specific) and then based on the success of the options strategy.

Finally, distributions drive many investors to covered-call CEFs because, compared with their straight equity counterparts, the rates are much higher (an average of 10% versus 6% at NAV). It's important to understand how the distribution is earned in this type of fund. Let's assume a flat market over the year so the option is not exercised. The call option is written 2% out of the money and expires in 60 days on stock XYZ. The option premium is 2.3%, or about 14% annualized (often funds roll the options from period to period). The fund overwrites half of its holding, pocketing a 7.5% annualized gain on the call option. On top of this, stock XYZ pays a dividend of 2.75% per year. Because the fund holds the stock it keeps the dividend, boosting the total return for the year to 10.25%, excluding any capital appreciation (or depreciation) over the year. Of course, the market is rarely flat over the course of a year and options will be exercised or underlying asset values will decline, making the distribution analysis more complex.

Of note is that many of these funds distribute return of capital regularly and as a large portion of the distribution. We wrote a detailed article about the reasons behind this and won't repeat the reasons here, but investors need to understand that not all return of capital is created equal. If the underlying net asset value is rising and the portfolio has racked up some unrealized gains, return of capital may be used to round out distributions instead of selling holdings they may continue to appreciate to meet distributions. Also, call premiums are not distributed as income, but capital gains. Therefore, the fund can use the premiums earned to offset capital losses with gains, leading to return of capital but also making for a good tax-advantaged future for the fund.

The table below lists the 31 covered-call CEFs with relevant strategy information, including the type of options a fund writes, the average "moniness" of the options when written, and the typical percentage of the portfolio that is overwritten. Keep in mind that these are averages and generalities that may not represent the current holdings and statistics. Most managers have leeway to decide how much of the portfolio is overwritten and how in-, out-, or at-the-money options are written depending on market conditions.

- source: Morningstar Analysts

In the search for income, investors often are wooed by high distribution rates and exotic strategies that they may not fully understand. While option strategies can provide a boost to distribution rates, they can be difficult to implement successfully. Most of the funds in existence today have track records longer than five years, providing investors a snapshot of how these funds perform in different market environments. Most of these funds lost less than their board peer groups in the 2008 market crash, but most also underperformed in the ensuing 2009 and 2010 recovery. Covered-call CEFs are not a magic bullet for income-hungry investors, but a carefully chosen fund can provide diversification and downside protection to any investor's portfolio.

Click here for data and commentary on individual closed-end funds. 

Cara Esser is a closed-end fund analyst at Morningstar.
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