Covered Call Closed End Funds (CEFs) have mouth-watering distributions ranging from 7% to 10%. This article will analyze the total return associated with covered call CEFs to assess if these yields are "too good to be true". But first, I will provide a quick tutorial on covered calls for the investor that may not be familiar with this class of assets.
A covered call strategy is also termed "Buy-Write" since it entails buying a stock and selling an at-the-money or slightly out-of-the-money call option against your stock position. There are many nuances associated with a covered calls but basically this is a way to receive income by selling some of the future upside potential of the stock. In the simplest form, a call option gives the buyer the right (but not the obligation) to purchase the stock at an agreed upon price (strike price) anytime before the expiration date of the option. The call buyer pays a "premium" for this right. If the price of the stock increases above the strike price before the expiration date, then the option buyer may "call away" the stock from the seller, i.e. the seller is forced to sell the stock at the strike price. This strategy can also be generalized to selling options on an "index" (like the S&P 500) rather than an individual stock.
Covered calls have been available to individual investors for a long time but were not embraced by funds until relatively recently. In 2002, the Chicago Board of Options Exchange (CBOE) launched the BuyWrite Index (BXM) based on selling near-term, near-the-money options on the S&P 500 index. Back testing this index showed that it often outperformed the S&P 500 with less risk (as measured by the standard deviation). This result generated interest in the investment community and in 2004 the first covered call CEF was offered by the Blackrock fund managers (the Enhanced Capital and Income Fund). More offerings followed swiftly and today there are over 30 covered call CEFs. To be classified as a covered call fund, call options must be written on more than 50% of the fund's assets.
By selling calls to augment income plus using leverage, the covered call CEFs often provide large distributions. However, to put these high yields in proper perspective, you have to make sure that these are "true yields" and not just return of your capital (ROC). Determining if ROC is "bad" or "good" is not as easy as you might think for covered call CEFs because ROC is based on definitions in the corporate tax code and is not necessarily synonymous with return of principal. However, if over the course of a year, the Net Asset Value (NAV) increases, then the fund earned more (either by income or capital gains) than it distributed and the distribution should not be considered destructive. Therefore, looking at total return rather than distributions is a much better way of appraising covered call CEFs.
To assess this class over a complete market cycle, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the CEFs from October 9, 2007 (the market high before the collapse) until today. The Smartfolio 3 program (smartfolio.com) was used to generate this plot. It turned out that about half of the CC CEFs (a total of17) did, in fact, beat the return of the S&P 500 over this period. These CEFs are listed in Table 1 and are plotted on in Figure 1. Generally, the call premiums helped to minimize losses during the 2008 bear market resulting in excellent relative return for these CEFs over the 5.5 year period.
Table 1: Covered Call CEFs
Figure 1: Risk Reward Covered Call CEFs Over Market Cycle
Somewhat surprisingly, investing in CEFs did not significantly reduce volatility. Only four of the CEFs (JLA, JSN, JPG, and JPZ) were less volatile than the S&P 500. Most of the other CEFs had volatilities similar to or slightly larger than the S&P 500. The only outlier was INB, which was substantially more volatile than SPY. In summary, it can be concluded that, over a complete market cycle, these CEFs rewarded investors but did not significantly reduce volatility risk.
Although a good asset class in a flat to down market, you would expect covered calls to suffer in a strong bull market. To assess this class of funds in a bull market, I plotted the return versus volatility of the 17 CEFs during the last three years. This plot is shown in Figure 2. As expected, the total return has been positive for all the CEFs but most have underperformed the S&P 500. Only NFJ and DPO had returns comparable to the SPY.
Figure 2: Risk Reward Covered Call CEFs (3 years)
Again, I was surprised at the volatility during the bull market. Most of the CEFs had volatilities similar to the SPY and the ones that have lower volatility also have lower rates of return.
By comparing Figure 2 with the distribution rates in Table 1, it becomes evident that, over the last three years, several of the CEFs (CII, EOS, ETB, ETV, ETW, ETY, ETG, IGA, JLA, and JSN) have a total return lower than distribution rate. This is a red flag that the high distributions came at a cost of reducing the NAV, in other words, these were examples of destructive ROC.
I also reviewed the correlation matrix for these CEFs. For the three year period under investigation, the correlations among the possible pairs are all greater than 70%. All the CEFs are also highly correlated with the S&P 500. Therefore you not are achieving a significant level of diversification by purchasing these CEFs.
For comparison, I also included PBP (the PowerShares S&P BuyWrite ETF) on the Figure 2 plot. PBP is the most liquid ETF in this category and has a yield of about 3.2%. It does have relatively low volatility but the total return is below most of the CEFs.
The bottom line of my analysis is that covered call funds (CEFs or ETFs) are a reasonable investment for long term investors and for investors expecting a flat to down market. However, you should beware of the high distributions and keep your eyes on the total return.