Covered Call Funds: The Whys and Hows

by: Roger Nusbaum

roger nusbaumRoger Nusbaum submits: A couple of weeks ago I put up a post about a guest on Street Signs named Bryan Perry who came up with some high-yielding investment ideas.

Yesterday he was back on with three covered call CEFs: Small Cap Premium & Income Funds (RCC), Blackrock Enhanced Equity Yield & Premium Fund (ECV) and S&P 500 Covered Call Fund (NYSE:BEP).

All three sell options and have colossal yields. Conceptually these are meant to track buy-write indices. There are various studies around that show the buy-write indices capturing most of the market's move up, with just a slice of the volatility. The following chart compares the three CEFs mentioned in the segment to the CBOE Buy Write Monthly Index (^BXM).

Buywrite Index vs CEFs 27 03 2007

As you can see, the three CEFs are much more volatile than the index (I realize that RCC is a small cap product and BXM is large-cap, but I didn't want anyone to go cross eyed looking at the chart), ex-dividend discrepancies notwithstanding, due primarily, I believe, to swings in the premium and discount to NAV although, RCC's NAV appears to be more volatile than the others (chart not pictured).

I am a very big believer in covered-call funds, I first wrote about them in October 2004, and have maintained a position personally and for clients in one of these types of funds for almost as long. But as the chart shows, they are not without volatility. I continue to urge moderation with the concept. All along I have talked about only one fund at a 3%-4% portfolio weight.

It was not clear to me from the CNBC segment if Mr. Perry was suggesting owning all three funds or not, but I would not take a larger position than 3 or 4% as a function of risk management. Too much of anything is not a good idea, and keep in mind I urge this moderation as someone who is very favorably disposed to the concept.

All of that being said, I would drop the one CEF I currently use in this space in a heartbeat if an ETF provider would create an ETF that mimics the BXM or the BXY (BXY is based on out of the money while BXM is at the money)....again at a 3-4% weight only.