Covered-call funds seek to fill income gap.
Judging from a slew of recent offerings, Wall Street
is betting that a high-yielding twist on an old fund idea will attract
investors looking for higher interest rates who are wary of fluctuating
Closed-end covered-call funds, which look to generate high income by selling call options on stocks in their portfolios, first debuted in 2004 and accounted for 85% of assets raised in the total closed-end fund initial public offering market last year, according to Ryan Beck & Co. in Florham Park, N.J. With yields in the 8% to 11% range, the funds were designed to tap investor demand for high income in an environment characterized by both low long-term yields available from bonds and the threat of rising interest rates. That makes them different from the majority of open-end, long/short or market-neutral fund mutual funds, which use covered-call writing and other defensive measures mainly as a hedge and don't generate yields nearly as high.
"Even though these are equity-based investments they are more suitable in a fixed-income application," says Alex Reiss, a closed-end funds analyst at Ryan Beck. "They are a good way to diversify a fixed-income portfolio because they do not have the same interest rate risk characteristics as bonds."
As their name suggests, covered-call funds implement a covered-call strategy that consists of writing call options against a group of underlying stocks to generate income. If the current market value of each security is above the strike price in the contract, the buyer will exercise the options and the writer must forfeit the stock at the specified price. If the option expires while the stock's current market value is less than the strike price, the writer keeps the income generating from writing the options, which is passed on to investors in the form of distributions.
The goal of the covered-call fund manager is to manage the portfolio to achieve the highest premium income possible while forfeiting the least amount of equity upside. The complexity of covered-call writing and the quirky and illiquid trading characteristics of closed-end funds make these investments suitable for those "with at least a moderate tolerance for risk," says Reiss.
Although the first fund hit the market about two years ago and most have been launched within the last year, covered-call, closed-end funds already have made an impact on the expanding market for high-yield products. According to the Chicago Board Options Exchange, 40 new buy-write investment products with $18 billion in assets, most of them closed-end funds, have been launched since the summer of 2004. With ten investment firms licensing the rights to offer products based on one or more of CBOE's four passive covered-call indexes, more funds are almost sure to follow.
The last time covered-call funds had such high visibility was during the 1970s, when a number of open-end funds that employed a covered-call writing strategy decimated their net asset values by using aggressive techniques such as investing in highly volatile stocks or employing aggressive options strategies that generated the highest premiums. Most had little or no regard to stock selection.
But fund sponsors are being more cautious this time around, says Wachovia Securities analyst Maria F. Bush. In an analysis of the funds, Bush writes that instead of selecting stocks that will generate the highest options premiums, managers are mindful of the outlook for the underlying stocks, or have portfolios that track broad indexes. And instead of distributing all of their premium income, as the older versions did, they are keeping some it to help offset market declines.
Still, many of the funds have lagged straight equity
offerings since their debuts. "The flaw with covered-call funds is that
they cap returns in bull markets, and in a crash or severe sell-off the
premiums aren't enough to offset a decline," says Thomas Herzfeld,
president of Thomas J. Herzfeld & Co. in Miami. "They are going to
do best in neutral to slightly rising markets."
Others advocate the use of covered calls as an effective way to moderate market ups and downs. Research from the Chicago Board Options Exchange, which licenses four buy-write indexes, suggests that over the long term the strategy can provide equity-like returns with more downside protection and less volatility than uncovered positions. Its latest creation, the S&P 500 2% BuyWrite Index, went live in March 2006 and is designed to leave room for price appreciation by selling out-of-the-money call options.
According to the exchange, this newest index produced annualized returns of 12.7% from June 1998 through February 2006, compared to 11.7% for the S&P 500 Index, and did so with less volatility than the overall market. The CBOE also licenses the S&P 500 BuyWrite Index, a passive total return benchmark designed to reflect a systematic call-writing strategy on the S&P 500 Index, as well as buy-write indexes based on the Dow and the NASDAQ 100. Back-testing on those indexes also points to the benefits of a systematic covered-call writing strategy.
Despite such evidence, concerns remain about the threat of net asset value erosion that plagued the old open-end option income funds. If a fund's yield exceeds the total return of the portfolio its net asset value will erode over time, warns Bush. Funds with the highest yields that write options against the entire portfolio carry the greatest risk of net asset value erosion, and when investors spend dividends rather than reinvest them that risk increases, she says.
"A good strategy with these funds is to reinvest dividends and take income on an as-needed basis," says Cristoph Hofmann, senior vice-president of Allianz Global Investors. "They don't have a specific coupon so income levels can fluctuate."
Reiss says buying closed-end covered-call funds at a discount to net asset value helps offset some of their risks and gives investors more yield bang for their buck. Recently, NJF Dividend Interest & Premium Strategy Fund, run by a subsidiary of Allianz, generated $2.10 of income per share on an annualized basis. That produced a yield of 8.53% based on the fund's net asset value, but an even higher 9.46% yield based on its discounted share price.
"The difference between share prices and net asset value tends to ebb and flow, depending on demand," says Reiss. "Therein lies the opportunity with closed-end funds. It's not uncommon to see discounts change 3% or more within a week, and investors can take advantage of that by adding to their holdings when discounts become unusually large."
The phrase "unusually large" remains open to interpretation at this point. Reiss says that because these products are so new, "it's hard to say where a fund's discount stands historically. As the market evolves over the next couple of years, it's going to be a feeling out process."
When the first closed-end covered-call funds came out in 2004 and early 2005 their shares sold at premiums for a short time, says Herzfeld. But after a glut of new offerings, those premiums went to wide discounts to net asset value of about 10%, a level he found attractive enough for purchase. "I'd be surprised if these funds ever trade at a premium," he says. "But if you buy at a discount to net asset value in the 10% range returns should be satisfactory."
Hofman is more optimistic. "As people begin to recognize the high income levels these funds produce, discounts could shrink and we could even see premiums," he says.
In addition to its discount level, a fund's investment and call-writing strategy also impact its returns. Some take their cue from a passive index, such as the CBOE S&P 500 BuyWrite Index. Launched in March 2005, the S&P Covered Call Fund seeks to approximate the performance of the BXM index by buying the common stocks of all the companies included in the S&P 500 in the same weighted proportions, and selling call options on the index. In mid-May fund shares were selling at a discount to net asset value of 8.4%, and had a yield of 10.78%. Year-to-date total return based on market price was 4.4%, about 2.4% below the uncovered S&P 500 Index.
Most closed-end covered-call funds are actively managed and differ in the extent to which they use options. Some implement 100% coverage, which generates the highest income but also limits upside potential. Others sacrifice some yield for a better shot at price appreciation by writing options on only part of the portfolio. A few funds use puts, futures, swaps and convertible bonds to augment a call-writing strategy.
Funds that Reiss finds interesting include the BlackRock Enhanced Dividend Achievers Trust and Nuveen Equity Premium Opportunity Fund. The BlackRock fund leaves room for price appreciation by covering only about 55% of the portfolio, but boosts yield by investing in high-dividend stocks. The Nuveen fund covers almost all of its portfolio and also uses put options to lock in profits if the market declines. As a bet on the out-performance of individual holdings, it uses call options on indexes rather than stocks.