As a retiree, I am continually looking for sources of high income but I also don't want to court excessive risk. This search led me to consider covered call Closed End Funds (CEFs). These funds offer excellent income (many with distributions more than 8%) but what about the associated risk? This article will analyze selected covered call CEFs in terms of their risk-to-reward characteristics.
Covered call funds write call options on their holdings to generate additional income. There are many sophisticated ways to use options and other derivatives within a CEF. However, the basic idea is simple. A fund will buy a stock and write (that is sell) a call option against their position. Since the fund owns the stock, the position is termed "covered." The call option will give the buyer the right (but not the obligation) to purchase the stock at an agreed upon price (called the strike price) any time before the expiration date of the option. For this right, the call buyer pays a premium to the writer. 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 fund, that is, the fund is forced to sell the stock at the strike price. If the price of the stock does not increase above the strike price, then the option expires worthless and the fund can pocket the premium. This strategy can also be generalized by selling options on an "index" (like the S&P 500) rather than an individual stock.
Covered calls are a way to receive more income than just the dividends paid by the stocks but in return, the fund sacrifices some of the upside potential of the stocks. In a bull market, you would expect the fund to under-perform the S&P 500 because many of the best performing stocks will be "called away." But during a correction, the premium provides a buffer to limit losses so, theoretically, writing covered calls should decrease volatility. This is not always the case in real-life since CEF portfolios are actively managed and performance is dependent on the specific strategy implemented by the fund.
A covered call strategy is also termed "Buy-Write" since it entails buying a stock and writing an associated option. 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 volatility). 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 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.
The covered call CEF investors should understand some of the unique aspects associated with Return of Capital (ROC). Return of capital has a bad connotation because it is usually associated with a fund literally returning part of the capital you invested. This is bad and results in a decrease in Net Asset Value (NAV). However, the exact definition of ROC depends on complex accounting and tax rules. For example, if a fund receives a premium from writing a call, this premium cannot be booked as income until the option either expires or is closed out. In addition, in a bull market, the fund manager may decide to not sell stocks that have greatly appreciated but instead use income that he has accumulated on his balance sheet to pay the distribution. In both these cases, part of the distribution may be labeled as ROC but it is not destructive. My rule of thumb is that ROC is not destructive as long as the NAV continues to increase.
There are currently 30 covered call funds listed on CEFConnect.com. To reduce my sample size, I used the following selection criteria.
- I wanted to analyze covered call CEFs over a complete bear and bull market cycle, so I chose CEFs that had a history going back to 12 October 2007 (the start of the 2008 bear market).
- The CEFs had to be liquid, with an average trading volume of at least 50,000 shares per day
- The distribution had to be at least 8%
- The Market Capitalization had to be at least $300 million
- Return of Capital, if any, had to be non-destructive
Based on these criteria, I reduced the number of CEFs to the following 12 CEFs:
- BlackRock Global Opportunities (BOE). This CEF sells at a discount of 11.6%, which is close to the 52-week average discount of 11.8%. This fund has 117 holdings, spread over all caps, with about 50% domiciled in the United States. The other major geographic areas for investment are the United Kingdom and Japan. The top two holdings are Google (GOOG) and Apple (AAPL) but these make up less than 5% of the total assets. The fund does not utilize leverage and has an expense ratio of 1.1%. The distribution is 8.6%, with a large portion coming from non-destructive ROC.
- BlackRock Enhanced Capital and Income (CII). This is the oldest covered call CEF with an inception date of 2004. It currently sells at a discount of 12.3%, which is below its average discount of 10.4%. This fund is relatively concentrated, with only 56 holdings, with 78% invested in U.S. companies. The largest holdings are Google and American International Group (AIG), each making up approximately 5% of the portfolio. The managers have a flexible mandate and can invest in all size companies but most are medium to large cap. The fund does not use leverage and has an expense ratio of 0.8%. The distribution is 8.7%, with a significant portion coming from non-destructive ROC.
- Eaton Vance Enhanced Equity Income (EOI). This fund sells at a 10.8% discount, which is close to the average discount of 10.9%. This fund contains 84 large cap holdings, all from the United States. The largest holdings are Google and Apple, each representing about 3% to 4% of the fund. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 8.1% consisting of income plus some non-destructive ROC.
- Eaton Vance Enhanced Equity Income II (EOS). This sister fund to EOI sells at a discount of 9.3%, which is slightly above its average discount of 10.1%. The fund has 84 holdings, all from the United States. The fund has a focus on technology with the largest four holdings being Google, Microsoft (MSFT), Apple, and Amazon (AMZN). Together these four stocks make up 15% of the portfolio. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 8.4%, consisting primarily of long-term gains and non-destructive ROC.
- Eaton Vance Risk-Managed Diversified Equity Income (ETJ). This CEF sells for a discount of 11.3%, which is slightly below its average discount of 10.8%. The fund contains 86 large cap stocks focused on technology, financials, healthcare, consumer discretionary, and energy. Most (96%) of the holdings are U.S. based companies with Google being the largest component, representing 3% of the portfolio. This fund has a unique option strategy-selling calls and using part of the income to buy puts. The puts insulate the fund during down markets (it only lost 6% in 2008) but holds back performance in bull markets. The fund does not use leverage and has an expense ratio of 1.1%. The fund has used destructive ROC in the past but currently the 10% distribution is currently paid from non-destructive ROC.
- Eaton Vance Tax-Managed Buy-Write Opportunities (ETV). This CEF sells at a discount of 7.5%, which is slightly less than its average of 7.9%. This is a large fund with 218 holdings, all from the United States. About 60% of the holdings are from S&P 500 stocks and the other 40% are from NASDAQ stocks. The managers have the discretion to overweight some areas and currently Apple, Microsoft, and Google represent about 18% of the total assets. The name "tax-managed" means that the fund managers try to minimize the tax burden by periodically selling stocks that have incurred losses and replacing them with similar holdings. This strategy has the effect of reducing or delaying taxable gains. The fund does not use leverage and has an expense ratio of 1.1%. The distribution was cut in January but is still a healthy 9.7%.
- Eaton Vance Tax-Managed Global Buy-Write Opportunities (ETW). This CEF sells at a discount of 8.1%, which is a smaller than the average discount of 9.8%. Over the last few months, the discount has been narrowing. This is a large fund with 472 holdings, with 54% from U.S. firms. After the U.S., the largest holdings are from the United Kingdom and Japan. Apple is the largest holding, representing 4% of the portfolio. The fund does not use leverage and the expense ratio is 1.1%. The distribution is 9.7%, paid primarily from non-destructive ROC.
- Eaton Vance Tax-Managed Diversified Equity Income (ETY). This CEF sells for a 10.4% discount, which is close to the average discount of 10.6%. The fund has 122 holdings with 77% from the United States. The rest of the holdings are primarily domiciled in the United Kingdom, Switzerland, and France. The fund typically writes options on the S&P 500 index rather than individual stocks. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 9.4%, consisting primarily of income and non-destructive ROC.
- Eaton Vance Tax-managed Global Fund (EXG). This CEF sells at a discount of 9.9%, which is close to the average discount of 10.1%. The fund has 136 holdings with about 42% in U.S. stocks and the rest in Europe. The largest holding is Royal Dutch Shell, which represents about 3.5% of the total portfolio. Calls are written against domestic and international indexes instead of individual stocks. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 9.8%, consisting primarily of non-destructive ROC.
- ING Global Equity Dividend and Premium Opportunity (IGD). This CEF sells at a 10.2% discount, which is much lower than its average discount of 7%. The fund has 135 global holdings with 45% from North America, 40% from Europe, and 15% from Asia. The fund managers have a flexible mandate that allows them to invest in individual stock options or index options. The fund does not use leverage and has an expense ratio of 1.2%. The distribution is a high 10.1%, paid primarily from income, capital gains, and non-destructive ROC.
- Nuveen Equity Premium Opportunity (JSN). This CEF sells at a 9.5% discount, which is below its average discount of 7.5%. The fund has 224 holdings, all from the United States. The fund usually chooses about 75% of its holdings from the S&P 500 and the rest from the NASDAQ. This fund does not use leverage and has an expense ratio of 1%. The distribution is 8.9%, paid primarily from income and non-destructive ROC.
- NFJ Dividend Interest and Premium (NFJ). This CEF sells at a discount of 4.6%, which is smaller than its average discount of 6.2%. The fund has 150 holdings, with 85% from North America and 15% from Europe. The fund has a unique strategy that invests 75% in equities and 25% in convertible bonds. The largest sector allocations are energy, financials, healthcare, and basic materials. The fund does not use leverage and has an expense ratio of 1%. The distribution is 10.1%, paid primarily from income and non-destructive ROC.
For reference, I also included the following Exchange Traded Funds (ETFs) in the analysis:
- SPDR S&P 500 (SPY). This ETF tracks the S&P 500 index and has an ultra-low expense ratio of 0.09%. It yields 1.9%.
- PowerShares S&P 500 BuyWrite (PBP). This ETF tracks the CBOE S&P 500 BuyWrite Index, which measures the return received by buying the 500 stocks in the S&P 500 and selling a succession of one-month, near-the-money S&P 500 index call options. The fund has an expense ratio of .75% and yields 5.1%. This ETF was launched in December of 2007 so its data does not quite span the entire bear-bull cycle.
Assuming equal weight, a portfolio of these CEFs averages over 9% annual distributions so these CEFs definitely satisfy my desire for high income but what about the risk? To assess the risk-adjusted return, I used the Smartfolio 3 program (www.smartfolio.com). Figure 1 provides the rate of return (called Excess Mu on the charts) in excess of the risk free rate. This rate of return is plotted against the historical volatility over a complete market cycle from 12 October 2007 to the present.
Figure 1. Risk vs. Reward since 12 October 2007
As illustrated by the figure, over a complete bear bull cycle, the majority of covered call CEFs had absolute returns comparable to the S&P 500 but somewhat surprisingly, they had volatilities greater than SPY. The BuyWrite ETF had a low volatility but also a low return. To better assess the relative performance of these funds, I calculated the Sharpe Ratio.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY. Similarly, the blue line represents the Sharpe Ratio of the BuyWrite ETF.
Some interesting observations are evident from the figure. Four of the CEFs (JSN, ETW, CII, and ETV) had risk-adjusted performance better than the SPY. Of these, ETV had the best performance. The next group of four (ETY, NFJ, EOS, and ETG) also had good risk-adjusted performance comparable to SPY. The performance of the last four funds (EOI, BOE, ETJ, and IGD) significantly lagged the other CEFs. The BuyWrite ETF had the worst risk-adjusted performance of all funds except IGD.
Next I wanted to see if the risk-reward characteristics were maintained over more recent periods where the S&P 500 was enjoying a rip-roaring bull market. I reduced the look-back period to 3 years and re-ran the analysis. The results are shown in Figure 2.
Figure 2. Risk versus Reward for covered call funds over 3 years
What a difference a few years made. As you might expect, in a bull market, a covered call strategy will have difficulty keeping up with the overall market. This is borne out by the data, which shows that the SPY outperformed all the covered call CEFs on both an absolute and risk-adjusted return basis. Most of the covered call funds were slightly less volatile than the S&P 500 but the decreases in volatility were not commensurate with the decreases in returns. On a relative performance basis, the CEFs that performed well over the complete market cycle continued to have good performance. NFJ jumped ahead of the pack and ETV continued its outperformance. Most of the other CEFs were tightly bunched around the "blue line." Three of the CEFs (ETJ, IGD, and BOE) continued to lag. It is also interesting to note that PBP performed well during this period, generating risk-adjusted returns on par with or better than most of the CEFs.
As a final stress test, I re-ran the analysis over the past 12 months, when the S&P experienced a truly impressive bull run. The results are shown in Figure 3. Over the past year there was substantial difference in the relative performance of the covered call funds. All the funds, with the exception of PBP and JSN, booked great double digit returns. The SPY continued its outperformance but it was matched by both EOI and EOS. During this bull period, all the funds, except for JSN, had a risk-adjusted performance better than PBP. Interestingly, JSN dropped to the bottom of the pack.
Figure 3. Risk vs. Reward for selected CEFs previous 12 months
Over several time periods during the past six years, covered call CEFs have held their own in both bull and bear markets. The relative performance of a particular fund depends on the look-back period, with funds excelling in some periods but lagging in others. However, over all the periods analyzed, ETW, ETY, and NFJ have generally been among the top performers. As always, past performance may not be a good predictor of future returns and volatility but I believe that risk-tolerant retirees should consider covered call funds for their income portfolio.