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Can Fund Investors Find Refuge in Covered Calls?

Option strategies add income to equity funds. 

Cara Esser, 07/11/2013

In the never-ending search for income, equity closed-end fund managers often boost income generation potential by way of derivatives. A popular strategy is selling 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. While there are a handful of mutual funds that implement buy-write strategies (the best-known being Gateway GATEX), it's more prevalent in the CEF world, likely because of their closed capital structure and general income focus.

Many investors are drawn to these funds for the outsized distribution rates ("yield") compared with other equity-based strategies, and a bonus is that the added income pads total returns when the broader equity market falls. For example, during the 2008 market crash, the exchange-traded fund SPDR S&P 500 SPY lost 37% and the average covered-call CEF lost 28.5%. Only three of the 25 in existence during at the time declined more than the ETF. To be sure, not all the funds invest in a domestic equity portfolio similar to the S&P 500 Index, but enough do that the comparison is still useful.

The Basics
First, a quick review on call options (for a more detailed look, read this article). Call options provide the buyer with the right 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. Time to expiration and the "moneyness" of the call option affect the premium as well. The longer the time to expiration, generally the higher the premium. "Moneyness" 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%-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). Finally, if the option is written on a single stock, the premium tends to be larger than an option written on an index.

The Results
The table below lists the 31 covered-call CEFs and compares their returns and distributions with those of SPDR S&P 500. Note that, while many equity CEFs use leverage, funds using this covered-call strategy generally do not. Only two of these funds (Cohen & Steers Global Income Builder INB and Guggenheim Enhanced Equity Income GPM) use leverage.

The funds' distribution rates are much higher than SPDR S&P 500's and also higher than those of ETF and mutual fund category averages. Astute investors will note, after some quick research, that these funds' distributions tend to include return of capital. It's important to understand the difference between destructive and nondestructive return of capital before passing judgment and also to note that when a fund is selling at a discount, destructive return of capital can be reinvested to the benefit of investors. What's more, some of the funds have good returns on a risk/reward basis, notably Nuveen's suite of option funds. Each fund has a three-year Sharpe ratio of 1.60 or higher, compared with the ETF large-blend and large-growth category average Sharpe ratios of 1.27 and 1.23 and the mutual fund large-blend and large-growth averages of 1.15 and 1.07.

There has been a lot of interest in equity strategies that reach for income as investors have grown wary of an overpriced bond market and have wanted to participate in the advancing equity market. Overall, covered-call funds can offer added income on top of an equity-based strategy. And an astute management team can take advantage of market volatility as the premiums for options tend to rise in such times. In our opinion, BlackRock's option team is one of the best at single stock option picking. The funds they manage have been quite successful, mainly BlackRock Enhanced Capital & Income CII and BlackRock Global Opportunities Common BOE. We also like Nuveen's suite of funds, managed by the option veterans at Gateway. Keep in mind, however, that the covered-call strategies tend to underperform when the market is advancing, particularly when it advances quickly as contracts are exercised. For example, SPDR S&P 500 gained 2.3% during May as the stock market continued its rise while the average covered-call CEF gained 0.45%. These funds might be used to lower the overall risk of a well-diversified portfolio and to boost income generation potential.

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

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