Equity CEFs:  When Option Funds Act Like Leveraged Funds

by: Douglas Albo


There are two main income strategies equity CEFs use to generate enhanced income. One is using a covered-call option strategy and the other is using leverage.

A leveraged strategy is, by far, more effective in a ramp up bull market like we are in, whereas the option strategy is most effective in flat to up-and-down market.

As a result, the vast majority of option CEFs' NAVs are not keeping up with their benchmarks, so why are investors rushing to buy them at premium valuations?

If investors are waiting for signs that we are in a blow-off top stage of the markets, we may be starting to see that in some equity CEFs. I watched in amazement last Friday, October 20th as the Nuveen S&P 500 Dynamic Overwrite fund (SPXX), $16.71 market price, $16.18 NAV, 3.3% premium, 6.0% current market yield, skyrocketed in valuation during the morning session and, at one point, was up 6.1% to $17.60 before quickly settling back down and closing the day at $16.71, up 0.7% and still at an all-time high 3.3% premium valuation over its NAV.

Now you must think that SPXX must have some super-charged exposure to the S&P 500 to get that kind of spike. I mean, why else would it have "Dynamic" in its name if the fund didn't use derivatives or some type of leveraged exposure to get that kind of a move? Even looking at SPXX's year-to-date market price performance of up over 21%, you got to think that it must have something that the S&P 500 doesn't, since the S&P 500 is up only 16.6% YTD with dividends by comparison (15% w/out dividends).

It's true that the SPXX does use something the S&P 500 index doesn't, but the problem is that it makes the fund more defensive. SPXX, like all option-income CEFs, sells call options against its portfolio of stocks (index options or individual stock options) to generate income that it passes on to investors in the form of enhanced distributions and yields. As most investors know, this is a defensive strategy since you give up the rights for future appreciation potential for current income.

And as you might expect in a ramp up market like this, selling call options against the value of your stock portfolio means you're probably giving up more in actual portfolio appreciation than you are getting in income. But that's the price you pay with option-income funds in a bull market, and where this shows up in an option-income CEF is that its NAV generally lags its benchmark. YTD, SPXX's NAV is up only 12.8% including all distributions, thus trailing its benchmark S&P 500 by almost 400 bps. Of course, a CEF's market price is free to go wherever investors take it, and in the case of SPXX, investors have nevertheless rewarded the fund with a market price up 21% despite the NAV underperformance.

So why would anyone buy an option-income CEF at a premium in a bull market if you know the fund's NAV won't keep up with its benchmark? And it's not just SPXX doing this. Take a look at the following table of option-income CEFs from BlackRock, Eaton Vance and Nuveen. All of these funds are index oriented (not sector specific) and represent some of the most popular equity CEFs among investors. The funds are sorted by their total return NAV performance YTD (boxed column) and I will go over a few of the more important highlights.

The first column to focus on is just to the right of the boxed column in the MKT/NAV Difference column. This shows you how much better most of these funds' market prices are performing over their NAVs so far this year. Only the Eaton Vance Tax-Managed Buy/Write Opportunities fund (ETV) and the Eaton Vance Tax-Managed Buy/Write Income fund (ETB) are showing worse market price performances than NAV performances, and much of that reason is because they are very defensive with their option strategy (95% option coverage) and because both started the year at elevated premium valuations to begin with.

However, the two columns I really want you to focus on are on the Benchmark MKT Difference and the Benchmark NAV Difference. These two columns compare total return market and NAV performances to each fund's relative benchmark and here you can see that most of the funds are outperforming their benchmarks at market price though only two, the BlackRock Science & Technology fund (BST) and the BlackRock Enhanced Equity Dividend fund (BDJ), are actually seeing their NAVs outperform their benchmarks.

On the negative side, why would anyone buy the Nuveen NASDAQ-100 Dynamic Overwrite fund (QQQX) at a 3.6% market price premium when the fund's NAV is trailing its benchmark PowerShares QQQ ETF fund (QQQ) by over 600 basis points (-6.3%)? Should QQQX be up 30.9% YTD, outperforming even QQQ with that kind of NAV performance? Absolutely not.

But this is what's going on. Now someone might argue that QQQX's NAV will hold up better if the markets turn more defensive and then the fund will be more effectively earning its 6.4% market yield if that happens. That may be true that QQQX's NAV will hold up better than QQQ if the markets turn flat or negative but in my experience with these funds, the market prices of option-income funds will drop just as much as any other CEF initially and they are more likely to fall further than their benchmarks.

And this is why I believe it makes more sense to buy ETFs than CEFs at this stage of the market cycle. Except for a few of the BlackRock option CEFs shown above, which I have been recommending over the past year or so, virtually none of the Eaton Vance or Nuveen option income funds are good buys now. You'd be a lot smarter to buy their relative benchmark ETFs and sell your own options against the position. You'd probably generate a higher annualized yield too.

Disclosure: I am/we are long BDJ, CII, BOE, DIAX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.