We looked here at the Dow Jones Industrial Average, and saw why it's not a great measure of U.S. stock performance, despite being a favourite index when it comes to media coverage. The S&P 500 is a much better barometer for the health of U.S. stocks, though an understanding of its calculation methodology is important in order to understand the limits to its usefulness.

The S&P 500 is essentially a market-value weighted index*, meaning a company's influence on the index is proportional to its size. This is much different than how the Dow Jones Industrial Average is calculated. Also unlike the Dow, the 500 stocks that comprise the index are chosen such that the index proportionally represents the economy's various industries. As such, the S&P 500 is not just the 500 largest companies. One interesting note is that despite being larger than almost every company in the index, Berkshire Hathaway (BRK.A) is not a component of the S&P 500.

Options are contracts that give their owners the right but not the obligation to buy (calls) or sell (puts) securities at a predetermined price (strike) at a predetermined period in the future.

If an investor is bullish on Microsoft (MSFT) when the stock is trading at $20/share, he/she could purchase calls and profit at options expirations week if the stock price increases above the strike price plus the price paid for the call. The options price consists of time value/time decay and an intrinsic value, which is the difference between the strike price and the current price of the security. Overall in quiet markets the time decay decreases the values of options. The time decay portion of the options price is sensitive to changes in volatility and could increase if volatility increases however.

A recent article in the WSJ titled “Buy-Write: Safe Harbor in Troubled Times?” by Brett Arends discussed the benefits of covered-call strategies. We believe there are many attractive characteristics to the strategy, and owning it in a closed-end format seems to make even more sense than other structures. Additionally, covered-call closed end funds are currently trading at deeply discounted levels. Below are some reasons we like the strategy pulled from the article. Also, we included a spreadsheet which describes the differences of the between the numerous covered-call closed-end funds (Covered Call Closed-End Cheatsheet).

1. Call options are usually overpriced. Those who sell them tend to make more money than those who buy.
2. The strategy "has generated superior risk-adjusted returns over the last 18 years… generating a return comparable to that of the S&P 500 at approximately two-thirds of the risk."
3. From 1988 through 2006, Callan said the buy-write strategy had made compound returns of 11.77% a year compared to 11.67% for the S&P, with much less volatility.
4. Over the past two years, someone who invested in a regular S&P 500 index fund would be down 43%. At the lows, early last month, they were down 54%.Over the same period, someone following the BXM would have lost a much more modest 25%. At the worst point they were down 37%.
5. Over a ten year period, buy-and-hold investors in the total US stock market have lost about 2% of their money. Investors pursuing a BXM strategy would be up about 13%.
6. From April 1989 to the present, the BXM has made total returns of about 400% -- slightly ahead of the broad US equity market. In other words, the buy-write index beat the stock market, with a lot less volatility.

While there is common mention of covered-call funds in this article and many others, authors fail to mention the differences between the funds, and how their strategies differ.We thought this would help.

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.

In the current environment, the front-and-center fears include: (1) A stubborn Fed that will refuse to cut rates until it is too late, (2) A stock market that may be a bit too exuberant, and (3) A consumer who will eventually be forced to spend less due to weak real estate and/or increasing gas prices.

How rational are the fears? Well, the Fed does have a long history of arriving late to the show. That said, interest rates are historically low and there's no genuine threat of the Fed raising rates. And while real estate as well higher gas prices have been dragging on the economy, the idea that the havoc and devastation are around the bend is somewhat irrational.

Roger Nusbaum submits: I got to thinking it might be interesting to see how some of the low beta, high yielding, defensive investment products came through the recent dip. The following list is not comprehensive; feel free to add any of your own.

• Claymore Sabrient Defender ETF (DEF) was down 3.00% on February 27 and from the close on 2/26 to the close on March 5 it was down 4.97%
• Claymore Yield Hog (CVY) was down 2.33% on February 27 and from the close on 2/26 to the close on March 5 it was down 5.52%
• iShares Dividend Select ETF (DVY) was down 3.21% on 2/27 and from the close on 2/26 to the close on 3/5 it was down 5.15%
• SPDR S&P Dividend ETF (SDY) was down 2.26% on 2/27 and for the same week as the others it was down 4.81%
• WisdomTree High Yielding Equity ETF (DHS) was down 2.80% on 2/27 and down 4.95% for the week measured as above
• Madison Claymore Covered Call Fund (MCN) was down 0.93% on 2/27 and down 1.73% for the week
• S&P 500 Covered Call Fund (BEP) was down 3.80% on 2/27 and down 5.56% for the week
• First Trust Covered Call Fund (FFA) was down 1.60% on 2/27 and down 3.98% for the week
• NFJ Div, Int, Prem Strategy Fund (NFJ) was down 2.91% on 2/27 and down 3.58% for the week
• Macquarie Infrastructure Trust (MIC) was down 1.52% on 2/27 and down 6.0% for the week
• Eaton Vance Enhanced Equity Income Fund (EOI) was down 2.15% on 2/27 and down 3.66% for the week
• Eaton Vance Tax Managed Diversified Equity Income Fund (ETY) was down 0.06% on 2/27 and down 2.35% for the week
• Alpine Global Dynamic Dividend Fund (AGD) was down 3.28% on 2/27 and down 6.26% for the week.
• DB Currency Harvest ETF (DBV) was down 1.75% on 2/27 and down 3.70% for the week.

For anyone who researches their own investments, the closed-end funds would probably be preferable because they won’t have the big sales charge and the recurring 12b-1 fees of the Van Kampen fund. Plus, once again, closed-end funds have the advantage of a stable asset base on which the calls can be written.

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.

As you start to look at these funds, it seems that there are two basic philosophical viewpoints:

Scenario 1: Efficient Market

Nature of the beast: Closed-end funds are offered at a premium to NAV at their IPOs; the premium represents the compensation to the underwriters, although few retail buyers understand this. Afterward, closed-ends frequently fall to discounts in the aftermarket.

Lack of investor understanding: Wachovia Securities analyst Mariana Bush says, "We think investors are selling their funds regardless of their NAV performance, to get rid of holdings whose behavior they cannot fully understand."

Wall Street maneuvers: A 1994 study by the Wharton School of Finance suggested that "enterprising" pros sell these funds to a "less informed" public. More often than not, these premiums disappeared when the underwriters withdrew so-called price support techniques after the offering, leaving the small investors holding the bag... Thomas J. Herzfeld places the blame for the current depressed prices squarely on Wall Street. "The underwriters pumped out whatever they could sell leaving no demand for these shares in the aftermarket."

Overly-high risk in pursuit of high yields: "Most of these funds have little or no chance of returning their eight, nine, ten percent yields without depleting their respective net-asset values," says another Chicago options trader.

Here is a chart to help explore what is going on with the call writing funds and the CBOE Buy Write Index (BXM), writes Roger Nusbaum. As a side note I had a miserable time trying to find a chart of the index.

The Businessweek dated July 4 has an article (I don't know if I utilized my subscription to access the article) about closed end funds that sell call options to create income, writes Roger Nusbaum. I have written about this product numerous times because I think it can be useful in a properly diversified portfolio.

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.

Any ETFs or Closed-End Funds that we haven't covered that you think we should? Leave a comment below.