CEFs: Look to Nuveen's Option-Income Funds for a Defensive Market

Includes: BXMX, QQQX
by: Douglas Albo

With the S&P 500 down about 6% and the NASDAQ down almost 7% from their highs set just five weeks ago, investors may be more worried about a more severe correction for the markets and may want to know which equity based Closed-End funds (CEFs) are more risk adverse. Here is where Nuveen has three equity-based high yielding CEFs which fit the bill. Though Nuveen is more known for their fixed-income CEFs, the large diversified financial services company also sponsors several equity CEFs that are popular among income investors looking for an added defensive measure in a market looking more vulnerable to the downside.

The Nuveen Equity Premium Opportunity fund (JSN), Nuveen Equity Premium Advantage fund (JLA) and the Nuveen Equity Premium Income fund (JPZ) are all equity based option-income funds that are a bit unique among funds of this income strategy because of their added downside protection.

Option-income CE's are defensive to begin with compared to other high yielding equity CEFs because their income strategy is to sell index or individual stock options against their portfolios to provide income for large dividends and yields. Though a down market won't stop option-income funds from losing value in their stock portfolios, their option strategy will at least help to offset the depreciation of their portfolios dependent on the amount of option coverage and other variables. Any investor who has done a covered-call option strategy knows that selling call options against their stock positions is a great way to reap additional income while providing some downside protection. If the markets or their stocks move sideways to lower, then typically the investor can keep the option premium sold and retain their stock positions. This is no different than what option-income funds are doing, except many funds are using indexes as opposed to individual stocks and the variables that the funds use also make them more or less defensive.

Whereas most investors would usually sell an option contract at a strike price above the current market price to allow for some additional upside to a stock position (called selling "out-of-the-money" options), Nuveen's option-income funds JSN, JLA and JPZ sell index option contracts below the current market levels to allow for a market drop. This is what is known as selling options "in-the-money," and allows the fund to earn higher premiums because of the lower strike price. The lower the strike price the fund sells the options, the more defensive the position and the more option premium the fund can earn. Of course, the downside to selling option-contracts "in-the-money" is that the markets move up and the value of the contract rises.

The other added defensive measure that Nuveen includes with these funds is that they sell 100% option coverage. In other words, for a fund that has a $500 million diversified stock portfolio, the fund will sell roughly $500 million notional value of index options against it. No other option-income funds I'm aware of sell options "in-the-money" on 100% portfolio coverage. This makes for a very defensive set of funds that, combined with discount market prices and high yields, can be very attractive in a more difficult market environment.

Data as of June 8, 2011

Note: JSN, JLA & JPZ are quarterly pay funds going ex-dividend on Monday, June 13, meaning an investor would need to purchase the funds by Friday, June 10th to be entitled to the dividend.

Disclosure: I am long JLA.