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Many closed end funds sell options against their holdings. They're called buy-write funds. Many investors do the same thing with their individual holdings. If you own Company A, you can sell options on Company A. This is a well-known conservative strategy that increases your income. It will also limit your gains if the stock increases rapidly.

This strategy by itself will never increase your losses because cash is immediately put into your account. In fact, if your stock drops, the option premium will soften the loss somewhat. Remember that if you hadn't sold the option, the stock would have dropped anyway.

Closed end funds may own hundreds of stocks. Some of them do the same thing investors do - sell options against many of their holdings. Some funds own so many of the S&P 500 stocks that they sell options on that index instead.

This creates a problem for us when analyzing the fund's performance because much of this option income is classified as a return of capital. But it's a good return of capital. It does not necessarily mean the fund is selling off assets to pay a distribution. Here are some simplified examples that explain what's going on:

1. If a stock on which an option is sold rises before option expiration, the fund may buy back the option at a loss, but the stock has risen by an identical amount. The fund keeps the option premium, but the fund's cash drops. The Net Asset Value (NAV) of the fund has risen by the amount of the premium. Compare it to a home owner before the housing bust. He had a valuable asset but he may have been cash poor.

If the fund pays a distribution in this situation, it will be designated a return of capital. Any time a fund pays a distribution that exceeds income, it's a return of capital.

An alternative for the fund in the above situation is to let the matching stock be called away. The fund keeps the premium, doesn't have to buy the option back, and sells the stock. It may be a gain or a loss, depending on the stock's basis. The original option sale, however, either increases the gain or softens the loss somewhat. Thus it helps the NAV a bit. The stock sale increases the fund's cash. If the fund pays a distribution from this cash it MAY be a return of capital.

Funds usually will buy the option back rather than let the stock go. The effect on NAV is the same either way but buying the option back can make the fund cash poor with an unrealized gain on the stock. Letting the stock go may result in a realized gain.

2. If the stock drops before option expiration, the NAV drops, but the premium from the expired option softens the loss to NAV. There is a short-term capital gain on the option to pay the distribution with. This is classified as income, which is taxable to investors. Since we all like to avoid tax, the fund may sell one of its holdings at a loss to cancel the option gain for tax purposes. The NAV is the same in either case, but a distribution from a stock loss would be a return of capital. A good fund manager will plan for this loss, because stocks are frequently volatile. Please remember the stock would have fallen regardless of the option sale.

A return of capital is tax deferred. Any such distribution will lower your basis in the fund. You'll pay the tax when you sell.

Any closed end fund that regularly pays distributions, whether or not it sells options, may have to make distributions in falling markets. If they're using dividends, it's not a return of capital. Otherwise it is a return of capital - the bad kind - where assets are being sold off to pay cash to investors. Will this ever apply to buy-write funds? It could, and the only way to know is to examine annual reports or 10-K filings with the Securities and Exchange Commission. Even then, I don't think the fund has to classify the nature of its return of capital. I for one do not closely examine all the number crunching and the footnotes in annual reports or 10-K filings.

To summarize, option premium always adds cash to a fund's portfolio. To avoid tax to investors, a fund might sell a stock at a loss to avoid a taxable distribution. This would be a return of capital. If a distribution is made from an unrealized gain on a stock, this may also be a return of capital.

The NAV is the only way I know to judge the health of a closed end fund. Since the net asset value of any fund goes up and down, there is uncertainty knowing just how a buy-write fund is doing. If this bothers you, then buy-write funds might not belong in your portfolio. You must be able to sleep at night. To graph the NAV of a fund, put an "X" before and after the symbol. So ETB becomes XETBX. And JPZ becomes XJPZX. With Yahoo charts (and perhaps other web sites), you can compare the fund's NAV with its actual price over any time period.

Source: The Tangled Web Of Distributions In Buy-Write Closed End Funds

Additional disclosure: I own one buy-write fund and I occasionally sell options against my own stocks.