An In Depth Look at the New Covered Call ETFs

Several new ETFs were recently released offering the covered call strategy on different indices or types of securities. They include:

Advent/Claymore Enhanced Growth&Income (LCM)
Enhanced S&P 500 Covered Call Fund (BEO)
Dow 30 Premium & Dividend Income (DPD)
First Trust/Fiduciary Asset Management Covered Call Fund (FFA)
Madison/Claymore Covered Call Fund (MCN)
S&P 500 Covered Call Fund Inc (BEP)

What do these funds do?
Their techniques vary and they utilize covered call strategy to varying degrees — enough to put them in the covered call category, but that is not necessarily all they do, as their descriptions and returns indicate.

The key to the covered call component is the assumption that the seller (writer) of the options will be right in selecting expiration and strike terms more often than the buyers – that the calls will expire valueless. The result is added ordinary income derived for the portfolio.

At the end of this article, we have provided a description of the approach taken by each fund.

What does BuyWrite mean? (from the CBOE website)

A ‘Buy-Write’ strategy generally is considered to be an investment strategy in which an investor buys a stock or a basket of stocks, and also writes covered call options that correspond to the stock or basket of stocks.

Buy-Write strategies provide option premium income that can help cushion downside moves in an equity portfolio, but Buy-Writes often under perform stocks in rising markets. Thus, some Buy-Write strategies significantly outperformed stocks in 2000 when stock prices fell, but Buy-Writes tended to under perform stocks in the years 1995 - 1998 when the S&P 500 rose by more than 20% per year.

Buy-Write strategies have an added attraction to some investors in that Buy-Writes can help lessen the overall volatility in many portfolios.

Are there benchmarks?
The CBOE created the S&P 500 BuyWrite index in 2002. That is the gold standard to evaluate the returns of covered call funds.

How well does the strategy work? (from the CBOE website)

In September 2004 the Ibbotson Associates consulting firm issued a case study on the investment strategy represented by the CBOE S&P 500 BuyWrite Index. The study was three-fold: 1) assess risk-adjusted performance of the BXM; 2) evaluate the role of this covered-call strategy in a portfolio; and 3) establish if an investor can implement the strategy.

A four page summary of the Ibbtoson study is available for download. Ibbotson found higher returns and much lower volatility for a the BuyWrite index versus the S&P 500 alone

Returns: 12.39% annual return for BXM versus 12.20% for S&P 500 over the 16 years covered by the study. The study hypothetically recreated the BXM back 16 years although the actual index was only 2 years old.

Volatility: 10.99% standard deviation of return for BXM versus 16.50% for the S&P 500 index.

You can see from their performance that the funds are doing something substantially different than the straight covered call technique represented by the CBOE BXM index. They vastly exceeded the index last year and do not track the BXM index closely at all.

It’s important to note that small, new funds are capable of achieving results that are more favorable than large mature funds, probably because they are more agile due to small size and because they can execute some trades without moving the market that a larger fund could not do.

Are these funds a good portfolio idea?
Perhaps “yes” in the long-term, but “no” for now. We think its always wise to give a new fund some room to prove itself or hang itself before committing money.

Most of these funds have so much leeway, that it is hard to know just what they are doing (just what you are buying) given the deviation between their returns and the BuyWrite index.

The covered call strategy is a conservative strategy with increasing appropriateness for investors as they grow older. If you can implement the strategy yourself with an index fund such as SPY while writing calls on your position, now may be a good time to include the strategy in your portfolio if reducing volatility is a priority.

These funds, however, are too expensive, too new, too illquid and too opague for effective use in a portfolio seeking volatilitiy reduction.

With only 19 basis points of added return from the strategy based on the index, it is hard to justify paying more than 100 basis points in fund management fees to buy that added return. On the other hand, these fund don’t seem to come very close to tracking the index. There are probably lower cost funds in other categories that can be used to reduce overall portfolio volatility on a more cost effective basis.

We don’t believe in chasing hot new funds, because they can just as well be tragic flame-outs in the next period. We recommend giving them more time to show their stuff and to decide just how they fit into a portfolio, and how much they actually turn out to be covered call strategy funds (or whether there is a lot of other stuff going on too).

A brief summary of each fund:

LCM: The Fund seeks current income and current gains from trading in securities with a secondary objective of long-term capital appreciation. The Fund invests primarily in equity convertible and non-convertible high-yield securities of U.S. and non-U.S. issuers. The Fund intends to engage in an option strategy of writing, selling, and covered call options on at least 50 percent of the securities held in the portfolio of the Fund. Allocation to international securities may provide an attractive alternative for portfolio diversification.

BEO: The Fund’s investment objective is to seek leveraged returns on the CBOE S&P 500 BuyWrite Inde (BXM Index) less fees and expenses. The Fund seeks to replicate the BXM Index by purchasing all of the common stocks included in the S&P 500 Index weighted in the same proportions as the S&P 500 Index or other investments that have economic characteristics similar to the securities that comprise the Index Second on an approximately annual basis the Fund will enter into swap contracts on the BXM Index that are intended to provide the Fund with leveraged exposure to the return of the BXM Index.

DPD: The Fund’s investment objective is to provide stockholders with a high level of current income with a secondary objective of capital appreciation. The Fund pursues its investment objective principally through a two-part strategy. First the Fund will invest under normal circumstances substantially all of its net assets (including the proceeds of any borrowings for investment purposes) in the thirty stocks included in the Dow Jones Industrial AverageSM ("DJIASM") (the “Stocks”) in approximately the amounts such stocks are weighted in the DJIASM and/or in other securities or financial instruments that are intended to correlate with the DJIASM (the “Other Instruments”). Second the Fund will write (sell) covered call options on some or all of the Stocks or Other Instruments.

FFA: The Fund’s investment objective is to provide a high level of current income and gains and to a lesser extent capital appreciation. The Fund seeks to achieve its investment objective by investing in a diversified portfolio of equity securities and writing (selling) call options on at least 80% of the Fund’s managed assets.

MCN: Its investment objectives are to provide a high level of current income and current gains and long-term capital appreciation. The Fund will pursue its investment objectives by investing in a portfolio consisting primarily of high qualitylarge capitalization common stocks that are in the view of the Fund’s Investment Manager selling at a reasonable price in relation to their long-term earnings growth rates. Under normal market conditions the Fund will invest at least 65% of its total assets in common stocks of large capitalization issuers that meet the Fund’s selection criteria

BEP: The Fund’s investment objective is to seek total returns through a covered call strategy that seeks to approximate the performance less fees and expenses of the CBOE S&P 500 BuyWrite Index. The BXM Index is a passive total return index that is based on buying the common stocks of all of the companies included in the S&P 500 Composite Stock Price Index weighted in the same proportions as the S&P 500 Index and writing (selling) call options on the S&P 500 Index.

Comments

[Roger Nusbaum:]

Mr. Shaw I believe your use of the term ETF is a tad confusing especially as you correctly note that these funds are CEFs in your table at the end.

As far as new; MCN's inception date is 7/27/2004, LCM 1/26/2005, BEO 9/28/2005, DPD 4/26/2005, FFA 8/24/2004, BEP 3/31/2005. How much time before a fund is not <em>new</em&g...

I would add there are probably another 20-30 funds in this genre.

To really know what value the fund management is adding would you need to char the NAVs as opposed to the market price?

I apologize for being so picky but the article seems to miss the mark.

2007 Jun 06 09:13 AM

[QVM Group:]

Roger,

Picky is good. Your suggestion that I should have stated that the fund are CEFs is appropriate. I am aware that there are more funds of the type, but I wasn't trying to make an encyclopedic study of the class, but to discuss features of the class. The particular funds used were actually selected by a client who received a proposal from an advisor who chose those funds as the best choices in the class. As you often do in your own blog, I was utilizing a real situation to discuss a theoretical point. I admit to conservatism by not accepting funds as necessarily mature with 2-3 years of history. That conservatism is particularly important in my with this class which seems to cyclically outperform and underperform the underlying index. This class has done well in the last 2-3 years during a period of cyclic outperformance. Because they have "juiced" their performance relative to the BuyWrite index, I would like to see how they do in period of underperformance of the strategy -- would their underperformance be a magnified to the downside as they have been to the upside? How the funds to relative to NAV is not important to me, because all I can experience is the price. are the price and distributions. Total return versus the benchmark index is what counts for me.

I edit my blog to properly note the type of fund as you suggest, and add a new post to deal with the cyclic performance issues that support my conservative view of time to maturity for this class of funds. If you would like to save me some time and email me the list of other funds in the class, I will do a more complete study (richard.shaw@QVMgroup... Thanks for the observations and keeping me on my toes.

Richard

2007 Jun 06 10:32 AM

[QVM Group:]

Roger,

I reflected on your comments and decided to redraft my blog on this topic. Since my principle purpose was to review and discuss the covered call strategy, I realized from your comments that by mentioning several funds, but not all of the funds in the category (many of which are following multiple simultaneous strategies), I was diverting attention from my principle point. In that respect you were correct to say that I was off the mark.

Consequently, I have totally rewritten my blog article to focus exclusively on BEP and BWV, which describe themselves as strict adherents to the single strategy of S&amp;P500 BuyWrite.

Your comment helped me focus on that point while leaving out essentially extraneous information about other funds which could be the subject of another article another time.

Thanks.

If you are interested, the revised blog article is at:

www.qvmgroup.com/inves...

Richard

2007 Jun 06 05:55 PM

[Roger Nusbaum:]

Mr. Shaw,

Thank you for the update, I read it but was not able to leave a comment...not sure I have a login for your blog's platform.

For anyone new to this, BXM sells at the money calls. There is another CBOE index with ticker ^BXY that sells calls 2% out of the money.

Additionally these indices exist in other countries, like Australia and a couple of others. I am hopeful that BWV from Barclays works out in terms of tracking. BEP has had some wild swings with its discount/premium to NAV. It looks like it has a 14% premium now which I'll pass on.

Thank you again for your time.

2007 Jun 06 09:19 PM

[yellowman98:]

Nice post (including revised blog &amp; comments by Mr. Nusbaum). As a newbie, I am understanding better how this investment idea works.

To me, seems like BEP is a good option if you're looking to roughly match SPY performance with less volatility, with the bonus of a 10% dividend, and don't mind the 100 basis points.

Is there a point a few years in the future when BEP will stop writing covered calls and it's dividend, and simply become an index fund and revert to its NAV? (I read some posts expressing this concern a few months ago) What happens then? Wouldn't that reversion make relvant how the fund trades relative to the NAV, especially for your entry point into the fund?

Thank you for sharing your opinion.

2007 Jun 14 01:36 PM

[QVM Group:]

I wouldn't recommend worrying about the end of the term of this fund. It was launched in 2005 and will be around long after you have made any investment. If you in the fund 10 years from now, look into that question if you wish.

I doubt that the fund will stop writing calls, because that process is why the fund exists. They would have to make changes that probably would require a shareholder vote. I can't imagine that possibility effecting the price-to-nav relationship.

Note that covered call funds exceed the performance of the underlying index in a sideways market and in a declinging market (although they do not limit the downside), but they cap the return on the upside.

If you have questions that are not answered by published documents, the best thing to do is to contact the sponsor. Typically, you can get the info you want "straight from the horses mouth".


S&amp;P 500 Covered Call Fund Inc
800 Scudders Mill Road
Plainsboro, NJ 08536
P: +1 609.282.5904


Fund web address:
www.iqiafunds.com/fund...

INVESTMENT OBJECTIVE
The Fund's investment objective is to seek total returns through a covered call strategy that seeks to approximate the performance, less fees and expenses, of the CBOE S&amp;P 500® BuyWrite
IndexSM (the "BXM Index").


INVESTMENT STRATEGY
The Fund will pursue its investment objective principally through a two-part strategy. First, the Fund will invest the proceeds in all of the common stocks included in the S&amp;P
500® Index weighted in the same proportions as the S&amp;P 500® Index and/or other investments that have economic characteristics similar to the securities that comprise that Index. Second, each calendar month during the term of the Fund, the Fund will write (sell) one-month call options on the S&amp;P 500® Index ("Written Options").

2007 Jun 14 04:13 PM

[KillerKev:]

You did not mention the new ETN with a lower fee than other strategies(75bps):

The iPathSM CBOE S&amp;P 500 BuyWrite IndexSM Exchange Traded Note (ETN) is expected to begin trading on the American Stock Exchange (AMEX) on or around May 23rd under the symbol "BWV". It will be the first ETN to offer investors cost-effective, tax-efficient exposure to the CBOE S&amp;P 500 BuyWrite IndexSM. The index tracks the total return of a hypothetical "buy-write", or "covered call", strategy on the S&amp;P 500® Index.

A buy-write strategy can help reduce losses from downside market performance in an equity portfolio. And now it’s as easy to implement as placing a single trade.

The new ETN will offer:

Risk reduction: Reduced volatility compared with the S&amp;P 500® Index.
Ease of use: Exchange traded, eliminating the need to manually execute and manage a portfolio of stocks and options positions.
Tax advantage: Will not make taxable distributions, enabling investors to control the timing of taxable events related to their investment in the new iPath ETN.
All iPath ETNs offer:

Transparency
Cost efficiency
Tax efficiency
Daily exchange liquidity
Get the BWV Term Sheet and preliminary pricing supplement.

2007 Jun 15 09:45 AM

[QVM Group:]

I did not mention BWV in this article, but covered it in a follow-up article at:
www.qvmgroup.com/inves...

2007 Jun 15 12:20 PM