Call writing (BEP, FFA, IGD, JPZ, JSN, MCN, NFJ)

by: Roger Nusbaum

My wife spent Friday night at a family function that I got out of because our new puppy needs a human present most of the time. So for fun I watched the Diamondbacks game and plugged the term covered call funds into Yahoo Finance to see what I would find.

The funniest thing was that a post of mine was number 14. Unfortunately I did not find too much there other than sites selling something, but I found a couple of things.

One site that was interesting was for some type of fund run by OZ Capital Management called the Covered Call Fund. I never found a ticker symbol and there were no performance numbers past 2001. Maybe this was a private fund and it is now no longer a fund?

The reason I am mentioning this is there was something strange on the site's strategy page. It said

"If your option is exercised your stock will be sold at the agreed price."

Any option people out there as nit-picky as I am see something odd in that sentence? Investors who buy options have the right to exercise their options at or before expiration (save for European indices). The resulting action of an exercised option is that the seller is assigned. A seller may get assigned not exercised. I realize it may just be me but if I was thinking about investing in this fund I would have to question the expertise of the managers.

The other interesting thing was a short commentary by Bernie Schaeffer dated April 27, 2005. Bernie appears on TV quite a bit and I have learned a few things from him over the years but I can't get a feel for how much he knows. Bernie expresses some of the concern I have expressed about the supply of covered call closed-end funds (CEFs) that has come to market in the last few months.

(A few examples of covered call closed-end funds: MCN, FFA, IGD, EOI, JPZ, JSN, NFJ and BEP.)

Bernie feels that that these portfolios could get "destroyed" in a major market decline. He further believes that the selling done by these funds has "created a stranglehold on volatility." Obviously volatility plays a major role in every type of options strategy. From the blogosphere, Jack Miller is no fan of these either.

I thought it would be worthwhile to look at a couple of open end call funds to see how they weathered a major market decline and then offer my two cents about the fate of the CEFs. I found two OEFs, KSOIX and DBCCX. If you click on them you will see that KSOIX has lagged badly at every turn and DBCCX has outperformed the SPX on a regular basis, but if you click here you will see DBCCX has lagged the CBOE Buy Write Index (BXM) by a lot. Galatime has also addressed this point on his site.

My original expectation for owning a covered call CEF was that I thought it would be less volatile that the market in both directions, have less interest rate sensitivity than a bond fund and provide an 8% yield. The fund I own has a 4% weighting in my account, not a particularly large amount for something I expect to behave more like a bond fund.

Bernie and Jack seem to have similar reasoning for not liking these funds and they may turn out to be correct. Since these CEFs came to be they have in fact generally behaved they way I thought. While we have not had a major market decline the SPX at one point declined about 9% from its early February high yet the group of CEFs did quite a bit better except the NFJ Strategy Fund (NFJ).

Also since the CBOE Buy Write Index came into existence in early 2002 it went down less and has bounced back faster than the SPX. At a minimum the strategy has merit.

I have a theory about the performance of KSOIX beyond just bad stock picking. Clearly when the fund was created in 1999 the world of call writing was much different. Premiums were very very high providing a lot of leeway for being wrong. This started to change early on in the life of the fund making proper portfolio construction more important than while the bubble was still inflating. In looking at the holdings on the Yahoo page I see a lot of big caps that have not worked including GM. I am hard pressed to give the manager, Matthew Kelmon, the benefit of doubt here but it is true that the covered call environment did change and probably had some impact.

But to conclude this long analysis these are working now as expected and the Buy Write Index has weathered some rough periods in its three plus years. If I turn out to be wrong I will have no problem making a change but given the results so far and the small weighting I maintain, I feel very comfortable with the concept.