As a retiree, I am a fan of covered calls as a way of achieving high income without courting excessive risk. In December of last year, I wrote an article on the risk and rewards associated with covered call Closed End Funds (CEFs). My conclusion was that these funds offered excellent income, many with distributions more than 8%, with risks similar to the S&P 500. This article will provide an update on these CEFs and will assess how the portfolio has fared over the past 6 months. This is the first of a two part article. The next article will relax some of my selection criteria so that I can assess some additional covered call CEFs that were not included in the original article.
Before I launch into the analysis, I will provide a quick tutorial for the investors that may not be familiar with this type of investments.
The basic idea of investing in covered calls is simple. An investor will buy a stock and write (that is sell) a call option against their stock position. Since the investor 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 (the investor who sells the option). 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 writer, that is, the writer 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 writer can pocket the premium.
Thus, covered calls are a way to receive additional income but in return, the writer sacrifices some of the upside potential of the stocks. In a strong bull market, you would expect the covered call strategy to under-perform the SP 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 true since volatility is dependent on the specific strategy implemented by the writer.
There are several ways for an investor to implement a covered call strategy. As described above, an investor may select a number of stocks and write covered calls against each of the holdings. Although simple in principle, actually implementing a profitable covered call strategy is not that easy. The investor must not only select a suitable stock but must also select the option to write (based on premium, exercise price, and time to expiration). After the covered call position is initiated, the position must then be actively managed to determine when to close the position, whether or not to roll the option and to decide what type of risk management techniques to use. Don't get me wrong. Writing covered call options on individual stocks can be rewarding but it is not for the "buy and forget" investor. I have developed some rules that have worked well for me personally and I plan to share them in a future article. However, for most investors, I believe it would be advantageous to buy a professionally managed covered call fund.
There are three types of funds that offer covered call portfolios: Closed End Funds (CEFs), Exchange Traded Funds (ETFs) and mutual funds. The article I wrote last December focused on CEFs but included ETFs and mutual funds for reference. This article will follow in the same vein.
The covered call CEF investors should understand some of the unique aspects associated with Return of Capital (NYSE: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 (NYSE: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 29 covered call funds listed on www.CEFConnect.com. For the December article, I used the following criteria to reduce my sample size.
- 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 over the past year
Based on these criteria, I selected 12 CEF, which are summarized below. As part of the summaries, I included comparisons between the current data and the data in December of last year. It should be noted that since December, the price of many of the CEFs have appreciated significantly and discounts have shrunk. The increased price has also caused the distribution to be less in percentage terms than the original 8% selection criteria (but all are still greater than 7%). In my next article I will relax the distribution and market capitalization criteria in order to analyze a larger set of funds. Also note that when I say that ROC has not been destructive, I am focused on distributions over the past year.
BlackRock Global Opportunity (NYSE:BOE). This CEF currently sells at a discount of 9.2%, which is less than the 11.6% discount in December. This fund has 124 holdings, spread over all caps, with about 47% domiciled in the United States and most of the others from Europe and Asia. The fund typically writes options on 40% to 60% of the portfolio. The fund does not utilize leverage and has an expense ratio of 1.1%. The distribution is currently 8.0%, down from the 8.6% offered last December. A large portion of the distribution comes from non-destructive ROC.
BlackRock Enhanced Capital and Income (NYSE:CII). This is the oldest covered call CEF with an inception date of 2004. It currently sells at a discount of 4.2%, which is less than the 12.3% in December. This fund is relatively concentrated, with only 60 holdings and 85% invested in U.S. companies. The managers have a flexible mandate and can invest in all size companies but most are medium to large cap. The fund typically writes options on 40% to 60% of the portfolio. The fund does not use leverage and has an expense ratio of 0.9%. The distribution is 8%, down from 8.7% offered in December. A significant portion of the distribution comes from non-destructive ROC.
Eaton Vance Enhanced Equity Income (NYSE:EOI). This fund sells at a 6.9% discount, which is significantly less than the 10.8% discount of last December. This fund contains 85 large cap holdings, all from the United States and writes options on 42% of the portfolio. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is currently 7.6%, down from the 8.1% of last December. The distribution is funded primarily from short term gains and non-destructive ROC.
Eaton Vance Enhanced Equity Income II (NYSE:EOS). This sister fund to EOI sells at a discount of 4.9%, which is less than the 9.3% of last December. The fund has 88 large and mid-cap holdings, with about 95% from the United States. The fund writes options on 44% of the portfolio, does not use leverage, and has an expense ratio of 1.1%. The distribution is currently 7.8%, down from 8.4% of last December. The distribution is funded primarily from long and short term gains with some non-destructive ROC.
Eaton Vance Risk-Managed Divers Equity Income (NYSE:ETJ). This CEF sells for a discount of 8.9%, which is less than the 11.3% discount of last December. The fund contains 83 large cap stocks with most (96%) of the holdings domiciled within the U.S. 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 writes options on 88% of the portfolio. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is currently 9.7%, which is slightly less than the 10% offered in December. The fund has used destructive ROC in the past but currently the 9.7% distribution is paid primarily from non-destructive ROC.
Eaton Vance Tax--Managed Buy-Write Opportunities (NYSE:ETV). This CEF sells at a small premium of 0.7%, which is substantially less than the discount of 7.5% of last December. This is a large fund with 208 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 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 writes options on 84% of the portfolio. The fund does not use leverage and has an expense ratio of 1.1%. The current distribution is 8.8%, which is slightly below the 9.7% of last December. The distribution is funded primarily by non-destructive ROC.
Eaton Vance Tax-Managed Global Buy-Write Opportunities (NYSE:ETW) This CEF sells at a discount of 3.4%, which is less than the 8.1% of last December. This is a large fund with 461 holdings, with 54% from U.S. firms. After the United States, the largest holdings are from Europe. The fund utilizes index options that cover about 93% of the value of the portfolio. Index options generally provide less income than call options on individual stocks. The fund does not use leverage and the expense ratio is 1.1%. The distribution is 9.1%, which is below the 9.7% offered last December. The distribution is paid primarily from non-destructive ROC.
Eaton Vance Tax-Managed Dividend Equity Income (NYSE:ETY). This CEF sells for a 7% discount, which is less than the10.4% discount of last December. The fund has 103 holdings with 87% from the United States. The fund typically writes options on the S&P 500 index rather than individual stock but the options cover only 43% of value of the portfolio. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 8.8%, down from the 9.4% of last December. The distribution is paid primarily from income and non-destructive ROC.
Eaton Vance Tax-managed Global Fund (NYSE:EXG). This CEF sells at a discount of 8.7%, which is less than the 9.9% discount of last December. The fund has 146 holdings with about 52% in U.S stocks and most of the rest in European securities. Calls are written against domestic and international indexes instead of individual stocks, with options covering 40% of the portfolio value. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 9.6%, which is slightly below the 9.8% of last December. The distribution consists primarily of income with some non-destructive ROC.
ING Global Equity Dividend and Premium Opportunities (NYSE:IGD). This CEF sells at a 6.2% discount, which is less than the 10.2% discount of last December. The fund has 112 global holdings with 50% from North America, with the rest from Europe (35%), and 14% from Asia. The fund managers have a flexible mandate that allows them to invest in individual stock options or index options. The fund writes options on 50% of the portfolio. The fund does not use leverage and has an expense ratio of 1.2%. The distribution is 9.5%, which is high but still below the10.1% offered in December. The distribution is paid primarily from income and non-destructive ROC.
Nuveen Equity Premium Opportunities (JSN). This CEF sells at a 3.6% discount, which is less than the 9.5% discount in December. The fund has 223 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. The fund writes options on virtually the entire portfolio. This fund does not use leverage and has an expense ratio of 1%. The distribution is 7.8%, which is less than the 8.9% offered in December. The distribution is paid primarily from income and non-destructive ROC.
NFJ Dividend Interest and Premium (NYSE:NFJ). This CEF sells at a discount of 1%, which is significantly less than the 4.6% discount in December. The fund has 158 holdings, with 87% from North America and 13% from Europe. The fund has a unique strategy that invests 72% in equities and 26% in convertible bonds. The fund writes options on 75% of the equity portfolio. The fund does not use leverage and has an expense ratio of 1%. The distribution is a high 9.8% but it is still below the 10.1% paid in December. The distribution is paid primarily from income and non-destructive ROC.
For reference I also included the following funds in the analysis:
SPDR S&P 500 (NYSEARCA:SPY). This ETF tracks the S&P 500 index and has an ultra-low expense ratio of 0.09%. It yields 1.8%. SPY will be used to compare covered call funds to the broad stock market.
PowerShares S&P 500 BuyWrite (NYSEARCA:PBP). This is the only ETF that is liquid and has a history that goes back to 2007. It 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 6.2%. This ETF was launched in December of 2007 so its data does not quite span the entire bear-bull cycle.
Gateway A (MUTF:GATEX). This is a mutual fund that invests in a broad diversified portfolio of 250 stocks and then sells index call options and buys index put options. The objective is to provide a steady cash flow with reduced volatility. Note that this fund has a load of 5.75% and a 0.9% expense ratio. The yield is 1.4%. I am not a fan of mutual funds that charge loads but I included this fund in the analysis as a reference to show how CEFs compare with more traditional mutual funds.
Assuming equal weight, a portfolio of these CEFs averages 8.7%, slightly down from over 9% in December, but still exceptional. I used the Smartfolio 3 program (www.smartfolio.com) to determine how this portfolio had fared since it was recommended last December. The results are shown in Figure 1 where the rate of return in excess of the risk free rate (called Excess Mu on the charts) is plotted against volatility. Note that this plot is based on price and not on Net Asset Value of the funds. NAV is a valuable metric for some analyzes but for risk and return I prefer price since it is the metric that determines actual profits and losses in your portfolio.
Figure 1. Risk versus reward since 1 December, 2013
Over the past 6 months since December, the covered call portfolio (shown as the red dot on the figure) has had phenomenal success, with a higher return and less volatility than the S&P 500. This is not too surprising since during this time period, the value of the S&P 500 has been in a relatively tight upward-sloping range. This mildly bullish uptrend is an ideal environment for writing covered calls.
Figure 1 illustrates that the CEFs had a large range of returns and volatilities. 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.
Some interesting observations are evident from the figure.
- On a risk-adjusted basis, the CEFs (except for EXG) handily outperformed both the ETF and the mutual fund and even booked better performance than SPY.
- GATEX achieved one of its objectives by lowering the volatility but it achieved this at the expense of return. On a risk-adjusted basis, GATEX lagged the other funds. Note that the return of GATEX did not take the load into account.
- The BuyWrite ETF achieved performance comparable to the S&P 500 and did so with lower volatility. This was impressive but PBP still booked a poorer risk-adjusted performance than any of the CEFs (except for EXG).
- Looking only at the CEFs, ETV had the best risk-adjusted performance with CII a close second. IGD came in third.
Thus covered call CEFs had an exceptional bull run over the near term along with the rest of the market. Note that the past 6 months of performance does not say anything about what might happen when the bear returns. In a bear market, the premiums received from writing calls does help to reduce the pain but not nearly enough to offset the drop in the underlying stocks. CEFs are even more vulnerable since investors will bail out and the discounts will increase significantly. For example, let's look at ETV which has been one of the best performing CEFs. For some periods during 2008, ETV sold at discounts exceeding 25%! ETV was launched in 2005 at a share price of $20 and during the horrendous bear market of 2008, the share price fell to under $10 a share. The morale to the story is that covered call CEFs are not "buy and forget" assets. Instead, investors should keep a close eye on the funds and exercise risk management when required.
As a last part of this review, I will update the long term view for these CEFs by running the analysis with a look-back period from 12 October, 2007 to the present. The results are shown in Figure 2. In this figure, I have also drawn a blue line which represents the Sharpe Ratio associated with PBP.
Figure 2. Risk versus reward since 12 October 2007
As illustrated by the figure, over a complete bear-bull cycle, a portfolio of covered call CEFs had about the same risk-adjusted and absolute performance as the S&P 500. Looking at the individual CEFs, four (JSN, ETW, CII, and ETV) had risk-adjusted performance better than 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 and the GATEX mutual fund had lower volatilities coupled with low returns, resulting in risk-adjusted returns that lagged all the CEFs except for IGD.
Covered calls ETFs have had exceptional performance over the past 6 months and have held their own over the entire bear-bull cycle. No one knows what the future will hold but if the bull remains healthy, investors looking for enhanced income with reasonable risk should give these CEFs serious consideration.
Disclosure: The author is long JSN, ETW, ETV. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.