Covered-call strategies in CEFs allow for higher distribution rates, but Morningstar's Cara Esser says investors should look for the underlying strategy first and not just the covered-call strategy.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. How do you use covered calls with closed-end funds. I am here today with closed-end fund analyst, Cara Esser to find out? Cara, thanks for joining me.
Cara Esser: Thanks for having me, Jeremy.
Glaser: So let's start with some basics. What exactly is a covered call? I know sometimes we talk about options and the terms get a little bit confusing. Can you walk us through exactly what that is?
Esser: Let's start at the very beginning. A call option provides the buyer of the call option with the ability to purchase a security at a certain price at a specified date in the future. When there is a buyer, there is seller. So the seller of the call option earns a premium from the buyer. The buyer is paying the seller for this option to purchase the shares in the future, and the seller is obviously required to sell the shares at the specified price, should the buyer like to exercise that option.
A covered-call strategy would be, from an individual investor's point of view, let's say, you own a stock, and you sell or write a call option on that stock. You are earning the call premium. But what you are doing is you are also selling some of the upside potential of the stock because if the stock rises past the strike price, it will be called and you don't get anything past what the appreciation was from the price that you bought it at to the strike price. But you do earn the call premium.
Glaser: We often think about this in the context of individual stocks. You mentioned if you own these shares, you are going to write the call on it. Does this also work for baskets of stocks for indexes or for other types of products?
Esser: It does. In the context of funds and closed-end funds in particular, there are two main types of strategies that you can use to do a covered-call portfolio. So one is a single stock option portfolio, which means, just what I said: You are writing individual call options on the individual underlying holdings. You can also do an index-based option portfolio which means you are writing calls on indexes that generally are representative of the underlying holding. So if you hold a basket of domestic equities, you might write a call option on the S&P 500 index for example.
Glaser: So we are giving up this upside, but obviously we're getting something for it. Why do investors want to do this? Why does it make sense to do a covered-call strategy with closed-end funds?
Esser: In a closed-end fund, the covered call is used specifically to generate more income on an equity fund. For example, the average equity closed-end fund has a distribution rate currently of about 6%-7%. The average covered-call equity CEF has a distribution rate of about 9%-10%. So the call premiums are really boosting the income. So if you are looking for an equity strategy that has additional income, you can get it from the covered call, but you do have to be aware that you are selling the upside potential. Just like on individual stock, if you are writing the call option, it works the same way the in the portfolio. So there's pluses and minuses.
Glaser: You mentioned how important the distribution is for people who are using this strategy, but what's the composition of that distribution? How much is coming from the covered calls? How much is coming from other activities that the fund is engaged in?
Esser: It's always important to understand where your distributions are coming from, and this is especially important with covered-call funds. Covered-call funds tend to distribute more return of capital than other equity funds and that's just because of the nature of the covered-call strategy. In a rising market, for example, the fund would be more likely to distribute return of capital, but it's generally not destructive return of capital. So that distinction is very important. Mostly it's because the call premium is booked and distributed to investors as capital gains as opposed to income. It's an accounting issue there, but we have a lot more information about return of capital on Morningstar's closed-end fund solution center, so anybody who wants to learn more about the ins and outs of destructive and non-destructive return of capital should go there.
Glaser: If we're looking at the closed-end fund world then, how many of these funds are utilizing these strategies, and which ones do you think are best positioned right now?
Esser: We have about 30 closed-end funds that we categorize as covered calls and to be categorized as a covered call, the fund needs to overwrite at least 50% of the portfolio's notional value. So there are a lot of funds that use a call strategy for less than 50%, such as 10%, 20%, or 30%, to boost the income just as we talked about earlier. But we don't categorize them as covered calls unless they overwrite a large portion of the portfolio. There's a wide difference between all the funds within the covered-call category; you have international funds, domestic funds, technology-related funds, and dividend funds. So you want to be sure that you really want to look for the underlying strategy first and not just the covered-call strategy.
There is a big difference between how much the fund is overwriting. Some of them overwrite only 50%, some of them overwrite a 100%. Then again you want to look at the single stock option versus the index option; there's pros and cons to each. So it's just a wide range of strategies within the covered-call universe.
But of some of our favorites, there is a fund called NFJ; that's the ticker. It invests in a value-oriented strategy, mostly domestic equities, and it also uses convertibles to diversify the portfolio and also increase the income-generation potential of the portfolio. We also like CII, and that's a fund from BlackRock. That is also a domestic equity closed-end fund, but we like this fund because it tends to not distribute a lot of destructive return of capital which is something that we're always looking for.
Glaser: Well, Cara, thanks so much for your thoughts today.
Esser: Thanks for having me.
Glaser: For Morningstar, I'm Jeremy Glaser.