In an era of low returns from fixed income investments, retirees have been attracted to covered call strategies as a source of income. Last week I provided an assessment of a portfolio of 12 covered call Closed End Funds (CEFs) and showed that this portfolio had handily outperformed the S&P 500 on a risk-adjusted basis during the past 6 months. I will refer to this portfolio as Portfolio 1. This article is a continuation of my covered call CEF analysis where I expanded by sample to include 10 additional covered call CEFs. The new sample includes CEFs with smaller distributions (but not necessarily lower total return) and CEFs with smaller market capitalizations.
Before I launch into the analysis, I will provide a quick tutorial for the investors that may have missed my article last week.
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.
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. In this article, I will assess the ROC relative to the distributions paid during the previous year.
There are currently 29 covered call funds listed on www.CEFConnect.com. I reviewed 12 of these last week and will cover an additional 10 in this article. The other 7 did not make the cut because of low volume or lack of a long history. The 10 new CEFs are summarized below.
Cohen & Steers Global Income Builder (NYSE:INB). This CEF sells at a discount 0f 2.8%, which is below its 52 week average discount of 6.3%. The portfolio has 246 holdings, with 89% in equity and 11% in other income focused securities such as preferred stock. About 54% of the holdings are domiciled in the United States with the rest invested primarily in European stocks. This is one of the few covered call CEFs that use leverage (currently about 20%). The other leveraged CEFs are DPO and GPM discussed below. INB has an expense ratio of 1.8% and the distribution is 8.8%, paid primarily from non-destructive ROC.
Dow 30 Enhanced Premium & Income (DPO): This CEF sells at a 3.9% discount, which is less than its average discount of 4.2%. The portfolio consists of the 30 stocks within the Dow Jones Industrial Average. In order to enhance income, the fund sells covered calls and other options (on roughly 50% of the holdings). The distribution is 6.4% with a substantial non-destructive ROC. The fund utilizes 25% leverage and has an expense ratio of 1%. The distribution is 6.4% with a substantial non-destructive ROC
Guggenheim Enhanced Equity Income (NYSE:GPM). This CEF sells at a 1.8% discount, which is less than its average discount of 4.8%. This CEF has only 5 holdings: S&P 500 (58%), iShares Russell 2000 (25%), PowerShares QQQ Trust (10%), S&P Mid-cap 400 (5%), and Dow Jones Industrial Average (2%). In addition, the fund writes index options on the holdings. The fund utilizes 20% leverage and has an expense ratio of 1.7%. The distribution is a high 10.1%, funded by short term capital gains.
Eaton Vance Tax-Managed Buy-Write Income (NYSE:ETB). This CEF sells for a discount of 2.3%, which is less than the average discount of 5.3%. The portfolio consists of 192 holdings, with 100% domiciled in the United States. The fund writes calls on 96% of the assets. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 8.1%, funded primarily by non-destructive ROC.
BlackRock Enhanced Equity Dividend (NYSE:BDJ). This CEF sells for a 10.2%discount, which is less than its average discount of 12.3%. The portfolio consists of 92 holdings, invested primarily in large cap equities from the United States. At least 80% of the portfolio is invested in stocks that pay dividends and options are written on 51% of the portfolio. The fund does not utilize leverage and has an expense ratio of 0.9%. The fund has a distribution rate of 6.8%, paid primarily from income and non-destructive ROC.
BlackRock International Growth and Income (NYSE:BGY). This CEF sells for a 6.2% discount, which is less than its average discount of 10.6%. The portfolio consists of 111 international securities with only 3% from the United States. The United Kingdom has the greatest percentage of the assets at 19% followed by Japan at 12%, Switzerland a 9%, France at 9%, and Germany at 8%. The fund does not use leverage and has an expense ratio of 1.1%. The fund writes calls on 45% of the portfolio. The distribution is 8.2%, paid primarily from non-destructive ROC.
Nuveen Equity Premium Income (JPZ). This fund sells at a discount of 7%, which is less than its average discount of 8.6%. The portfolio consists of 246 holdings, all from the United States. The fund sells index call options that cover 100% of the portfolio. The fund does not utilize leverage and has an expense ratio of 1%. The distribution is 7.8%, paid from income and non-destructive ROC.
Madison Covered Call and Equity Strategy (NYSE:MCN). This fund sells for a discount of 9.7%, which is below its average discount of 11.9%. The fund is relatively concentrated with only 48 holdings, consisting of 77% equity with the rest in short term debt, bonds, and other funds. All holdings are domiciled in the United States. The fund writes options on the majority of the portfolio. This fund does not use leverage and has a low expense ratio of 0.8%. The distribution is 8.4%, paid from long term gains and non-destructive ROC.
Voya Global Advantage & Premium Opportunity (NYSE:IGA). This CEF sells at a discount of 8.6%, which is about the same as the average discount of 8.5%. The portfolio has 120 holdings, all invested in equities, with 56% domiciled in the United States. The rest of the holdings are from Europe and Asia. The fund sells call options on indexes and securities to cover from 50% to 100% of the portfolio value. The fund does not use leverage and has an expense ratio of 1%. The distribution is 9.3% consisting of income and non-destructive ROC.
Voya Risk Managed Natural Resources (NYSE:IRR). This CEF sells at a discount of 115, which is slightly below the average discount of 11.5%. This is a unique covered call fund since all the holdings are from the energy and natural resource sectors. The portfolio has 125 holdings, all in equities with 85% from the United States and most of the others from Canada. Call options are written on from 30% to 80% of the portfolio value. The fund does not use leverage and the expense ratio is 1.2%. The distribution is 9%, paid primarily from 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.
Using equal weights, I constructed a portfolio that I will refer to as Portfolio 2. The average distribution of this new portfolio is 8.5%, which is only slightly below the average distribution of 8.7% that was received from Portfolio 1.
Last week I plotted risk versus return for Portfolio 1 for the past six months (since 1 December, 2013). This article provides the same data for Portfolio 2. The data is shown in Figure 1, which plots the rate of return in excess of the risk free rate (called Excess Mu on the charts) 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, Portfolio 2 (shown as the blue dot on the figure) has had performance similar to Portfolio 1(shown as the red dot on the figure). Both portfolios have had exceptional performance over the time period, with higher returns and less risks 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.
- The BuyWrite ETF achieved risk-adjusted performance almost the same as S&P 500.
- On a risk-adjusted basis, most of the CEFs handily outperformed both the ETF and the mutual fund and even booked better performance than SPY. The three CEFs that lagged (IGA, BGY, and GPM) had performance close to PBP and 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.
- Looking only at the CEFs, IRR had the best risk-adjusted performance, with ETB coming in second. INB and BDJ had risk-adjusted returns only slightly less than ETB.
- INB is one of the three CEFs that utilize leverage. The leverage may have helped INB receive higher returns but may have also increased volatility. The other two leveraged funds had higher volatility but did not have spectacular returns.
- Portfolio 1 and Portfolio 2 had about the same risk-adjusted returns.
Thus all the covered call CEFs that we have reviewed have had an exceptional bull run over the near term. 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 ETB which has been one of the best performing CEFs. For some periods during 2008, ETV sold at discounts exceeding 20%! ETB 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. In fact, most of the covered call CEFs are selling at prices less than the inception prices but still have positive total returns over the period due to their large distributions. The lesson learned 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. It is interesting to note that IRR, with its energy focused portfolio, only declined about 12% in 2008.
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 (the beginning of the 2008 bear market) 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 the bear-bull cycle, Portfolio 2 had about the same performance as Portfolio 1 and both have about the same risk-adjusted and absolute performance as the S&P 500. Some other observations about the individual CEFs are discussed below.
- Only three (ETB, DPO, and JPZ) had risk-adjusted performance better than SPY. Of these, ETB had the best performance.
- INB had a high return but also a high volatility so that the risk-adjusted return fell slightly short of the SPY performance.
- The managers of DPO and INB appeared to be using leverage productively.
- The leverage used by GPM did not appear to result in increased returns.
- The tightly bunched group of MCM, IRR, GPM, BDJ, and IGA had performance better than PBP but less than SPY.
- 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 BGY.
The two covered call CEF portfolios had about the same performance over the past 6 months and have outperformed the stock market over that period. Over the longer term, the two portfolios have held their own with respect to the broad stock market. Some individual CEFs have outperformed while others have lagged. Therefore, it is imperative to exercise due diligence when considering buying a particular CEF. 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 DPO, IRR. 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.