Further Thoughts On Call-Writing Closed-end Funds (BEP, FFA, IGD, JPZ, JSN, MCN, NFJ)

After a recent article that I wrote here on Closed-End Funds (CEF’s) that apply the strategy of writing covered calls against their portfolio holdings, I received a number of interesting responses, comments, and questions. My overall impression is that many investors (and potential investors) are somewhat confused about the nature of this strategy. I also note that this strategy is one that a number of wealth managers are suggesting for their clients. I recently listened to a couple of pitches that emphasized the value of writing covered calls as a strategy.

The general concept of selling call options against your portfolio is just fine—it’s the fact that many people do not grasp the implications of this strategy that bothers me. In particular, I have now seen a number of articles and gotten the explanation from a number of folks that state that the premiums that you collect when you sell covered call options can be regarded as income and treated, therefore, like dividends. This is an enormous misconception and it likely to end in a lot of hard feelings when either (1) the market rallies, or (2) volatility increases. At first, I thought that I did not understand what was going on when I read proposals that treated dividend income and option premium as similar sources of income in the portfolio. I have now seen and heard this explanation a number of times --- I get what these managers are doing -- and the pitch is often patently incorrect. To treat dividends and option premiums as the same thing in looking at a portfolio is an apples and oranges comparison.

Dividends are earnings returned to shareholders—they are true income. Option premiums are not the same thing. When you sell an option, you are selling what is called a ‘contingent claim’ against your portfolio. This means that in return for the option premium you are paid, you have a future obligation to the option buyer to sell him your shares at a specific price. Dividends are income with no future claims. I thought of a nice example to show how ridiculous it is to treat option premium as pure income. Imagine if you pay your homeowner’s insurance on January 1, 2006. Does your insurer treat this as income? Of course not. Your insurer has provided you with a contingent claim. If your house burns down, they will pay you some money. The insurer is like the investor selling a covered call. The insurer/call seller receives a premium in exchange for the promise that can potentially be costly to fulfill (building you a house or buying back your stock). When you sell a contingent claim, you must keep most or all of the premiums you collect in anticipation of the day when you have to fulfill the claim against you. The insurer banks the majority of the premiums he collects as reserves against disaster and you, the investor, should bank the vast majority of the premiums you collect from your covered calls against the day when the calls are exercised. An insurer who treats collected premiums as pure income is committing fraud.

A slightly more complex fallacy about call writing strategies is that the option premium can be treated as income once the term of the option ends. Is this correct? The answer depends on whether you plan to keep pursuing this strategy. If you write a covered call, collect the premium, and do not have the option called prior to expiration---and then never do this again—the premium is income. If you plan to consistently pursue this strategy over time, the odds will even out and you cannot consider this as premium. To pursue our example, if an insurer closes its books and allows contracts to expire, any money left in reserves may be considered income. If the insurer plans to write more insurance, premiums on the books—including those left from prior terms—cannot be considered as income.

Insurers make money because they charge more than fair value for insurance. If they calculate that the actuarial fair value of insuring my home for a year is $2000, they charge me $2000+. The “+

Comments

[Internet2k4]

This is a helpful explanation of the difference between CC fund payouts and dividends, but I'm a little perplexed by this analogy: "The insurer banks the majority of the premiums he collects as reserves against disaster and you, the investor, should bank the vast majority of the premiums you collect from your covered calls against the day when the calls are exercised." It's the CC fund, not me, who is charged with protecting against the downside risk of the strategy - as an investor, once I get my monthly check it's "from my cold dead hands." As an investor, I need to know enough about the CC fund model and consequent market risk to guess that the monthly check is enough to offset it - the 5% CC fund yield spread over dividends has to be for risk and sacrifice of growth. Hopefully these are taken on intelligently on the same basis as high-yielding but more familiar junk bonds or energy trusts. It appears there are well and poorly run CC funds as is the case for insurance companies and even dividend-paying corporations (which now and then founder.) If there is some deeper undisclosed risk associated with the model or management of some particular CC fund such that the yield is either too low or is unsustainable, I hope it will be exposed here - but I haven't read anything beyond the obvious, that my monthly check comes at the expense of underperforming the assets held by the fund.

[mlangner]

Geoff - I am struggling with your exact issue in my fund (and an ongoing battle with my administrator) - we have a strict price target methodology and occassionally sell out of the money covered calls at strikes at or above our price targets. If we get called in - no worries because we had that target anyway and would have been gone from the stock so the income is a bonus, if it expires worthless that's good too... Essentially we are trading gains in the stocks that we would never see for that income. If we get the underlying call on the stock wrong (not often but it happens) then selling the calls can be a hedge against a loss in that position...

The problem I have is calculating the value of the position while its open. My admin wants to treat the two transactions as seperate - recording the value of the written call in the same fashion as you would account for a short position - marking the position to market at the end of the month... This has two problems for my NAV calcuation - first it gives investors that invest after I open a covered call position a "free ride" on risks that prior investors had taken when that position was taken (e.g,. the fund would still have the same absolute liability associated with that trade whether or not that later investor invested) and 2.) because we are betting that the stocks go up - we expect the value of the calls to increase (until they reach a point of time premium decay) in concert with the underlying stock position... so the covered call shows a phantom "loss" - artificially depressing the NAV of the fund..

My goal is to find a proper way to value the premium in the interim between opening a position and when the call either expires, is called in or has to be bought back... no one has been able to give me a good answer on this - suggestions?

[Chamois16]

I'm not an options expert, but believe some of the basic premises in the argument are false. Options do not need to be priced inefficiently to "earn" a total return above the distributions; one does not need to rebuy the original stocks called away, and many CEF deal in index options, which are settled in cash when exercised, rather than by the exchange of shares. Strike prices, as has been mentioned, can be set to reflect targets.

The options writing CEF I follow have done as well as, or better than, expected, with NAV total returns well in excess of total distributions. NAI, for example, about twice as well in NAV total return with an NAV gain of over 10% net of distributions.

To debate whether the distributions are true dividends, if I understand the comment, is somewhat moot, since they are not dividends as defined by the ICA 1940, the SEC or GAAP, when portions include capital gains a/o other return of capital. Only in tax terminology can distributions be considered dividends and then not always.

I believe that whether a CEF makes sense or not as a concept depends largely on management. In this case, it probably depends more on the options advisor than on the stockpicker, usually separate teams.