One of the more popular income strategies is to use a buy-write option strategy to sell option premiums for income. This is simply owning 100 or more shares of stock, and selling a one covered call option per 100 shares of stock. While many investors use this strategy in their portfolios, others invest in closed-end funds that use this strategy and distribute the proceeds to shareholders. This is a great strategy in specific type of markets, such as sideway movements in the general stock markets. The biggest myth to this strategy is that covered call writing does not work and the CEFs are only returning the investors' capital disguised as distributions. This is incorrect, as return of capital by CEFs is based on accounting definitions when using option strategies like covered call trades.
Most of the CEFs that use an option strategy will use return of capital (ROC) for a portion of its distributions. Many investors see the ROC and throw these CEFs back into the market. Let’s explore why the ROC is such a negative issue for investors. It starts with the common definition of ROC.
The common definition of return of capital goes like this:
Return of capital refers to payments back to "capital owners" (shareholders, partners, unitholders) that exceed the growth (net income/ taxable income) of a business. The ROC effectively shrinks the firm's equity in the same way that all distributions do. It is a transfer of value from the company to the owner. In an efficient market, the stock's price will fall by an amount equal to the distribution. Most public companies pay out only a percentage of their income as dividends. In some industries it is common to pay ROC. (Wikipedia)
If these CEFs are returning capital, shouldn’t this be reflected in the share price or NAV? The answer is no to CEFs utilizing an option strategy. These CEFs may write a call option for 3 to 6 months, or even 1 year of time or more. The premiums received for the call writes is not considered income until the position has been completed or ended. Therefore, the CEF has the cash premiums but it can’t be considered income because the option trade has not ended. When this cash is used for distributions, it will be classified as return of capital instead of income. In reality, this distribution was not a result of returning cash from exceeding the growth of income and it is not a transfer of equity value from the company to shareholders. The distribution is merely classified as return of capital because it does not meet the terms of recognized income yet. This should not be considered a negative event for CEFs using option strategies. Of course, this return of capital theory does NOT apply to those CEFs that do NOT utilize an option strategy while returning capital. In these cases, the definition of ROC shown above may be correct.
Looking beyond ROC, covered call CEFs had a difficult year in terms of price returns in 2010. These CEFs hold positions in many stocks used as the underlying securities to write calls against. The big market pullback in August dropped the share price of these CEFs due to the decrease in the price of stocks held in the funds. A market price drop like inAugust is detrimental to covered call positions and will take some time before the covered write trades can recoup these losses. On the positive side, this has increased the discount percentages on many of these CEFs so now is a good time to look at these CEFs as an income investment.
The table below displays a summary of the CEFs in the covered call sector. The total return is a basic calculation of price return plus distribution rates. The Z score indicates which CEFs are trading at a bigger discount than the average over the last year. A Z score below -2.0 is a steep discount while anything over +2.0 is at an extreme premium.
The great thing about high yield CEFs is that the distributions offset a large portion of price decline in a bad year. You can clearly see this in the total return column in the table below. All of the CEFs in the table use ROC in their distributions. Two of the best performing buy-write CEFs below include NFJ and ETV, both of which will be discussed here.
NFJ Dividend, Interest & Premium Strategy (NYSE:NFJ) is one of the best performing covered call CEFs. The fund's value-based equity strategy is primarily rules-based. Analysts run screens to find stocks that have low valuations and high dividend yields (compared with the S&P 500 and the Russell 1000). In order to avoid stocks with negative momentum, they avoid stocks with falling prices and those that have experienced recent downward revisions by analysts. On top of the equities, the portfolio uses a call-writing strategy that earns premiums, adding to income-generation potential. Also appealing is the fund's lower-than-average 2010 expense ratio (0.98% versus 1.10%). Combine low expenses with decent performance and the fund looks even better.
The fund's distribution rate was recently increased by 200%, putting it on par with peer distribution rates (previously it was the lowest in the group). After a big 33% loss in 2008 (the average covered call CEF lost 29%) and a moderate gain of 21% (on par with peers) in 2009, its strong comeback in 2010 (up 12% versus the peer average of 8%) has boosted performance over the latest three-year annualized period. The fund is up 14.5% versus 12.55% for peers and 12.7% for the index.
Eaton Vance Tax-Managed Buy-Write Opportunity (NYSE:ETV) has low fees, and longer-term performance measures show strong outperformance of peers because of its 40% concentration in Nasdaq 100 stocks, which have performed well over the past three years. Of the eight Eaton Vance covered-call funds, this fund has performed better. We attribute this to its allocation to Nasdaq stocks as the index has significantly outperformed the broader S&P 500 Index in recent years. The fund is based on a 60%/40% combination of the S&P 500 Index and the Nasdaq 100 Index. Since 2007, the fund has only outperformed the combination index in two calendar years, 2008 and 2009. During 2008, the fund's performance was boosted by its call-writing strategy, which generated income as the overall portfolio lost value. This is the nature of a covered-call strategy.
The portfolio writes call options on the S&P 500 Index and the NASDAQ 100 Index. The fund will write call options to cover 100% of the portfolio's notional value. Options are written either at the money or just out of the money, and are short term in nature (less than three months, typically). Options are traded when another option has a higher implied volatility (which translates to a higher premium). The fund's adjusted expense ratio in 2010 was 1.07%, slightly lower than the peer average of 1.11%.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.