An In Depth Look at the New Covered Call ETFs

| About: S&P 500 (BEP)

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 (NYSE:LCM)
Enhanced S&P 500 Covered Call Fund (BEO)
Dow 30 Premium & Dividend Income (DPD)
First Trust/Fiduciary Asset Management Covered Call Fund (NYSE:FFA)
Madison/Claymore Covered Call Fund (NYSE: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.

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