Call-Writing Closed-end Funds: Hard To Judge Future Risk/Return (BEP, FFA, IGD, JPZ, JSN, MCN, NFJ)

by: Geoff Considine

There has been considerable discussion about closed-end funds that apply the strategy of writing covered calls. Roger Nusbaum has valuable insight into the features and challenges associated with these CEF’s (see articles on call-writing CEFs). The basic idea here is that you have a fund with two sources of income: premiums that you receive for selling call options and the dividend stream that you receive from owning the underlying stocks.

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

Scenario 1: Efficient Market

In the most simple-minded scenario, options are always priced efficiently in the market—they trade at ‘fair value’. The fund sells covered calls and makes money from option premiums. The fund also loses the potential upside from the movement of the stock price above the strike of the options. The fund also generates an income stream from dividends. If the market is efficient, there will be no net gain to this strategy over time. You will tend to look good when the market shows low volatility or is in decline and you will tend to look bad when the market rallies or when volatility is high. In this case, a fund that sells covered calls will end up, in the long-term, providing lower total returns with lower volatility than simply holding the basket of assets.

Scenario 2: Inefficient Market

In an inefficient market, fund managers may feel that they can price the options better than the market as a whole. The manager will buy stocks and sell the calls when he thinks that the market is over-estimating the future volatility in a stock. If the manager can value options better than the overall market, the fund will generate a risk-adjusted return greater than simply holding the underlying asset. Plenty of hedge funds and proprietary trading desks pursue this kind of strategy.

If you believe in Scenario 1, the only reason that you will invest in these funds is that they should provide lower risk returns than the underlying basket of assets and are thus well suited to income investors. If you are the kind of person who believes that active fund management is a waste of time, you are likely to fall into Scenario 1. If fund managers can’t beat basic asset allocation strategies, why should they be able to predict volatility better than the options markets?

If you believe in Scenario 2, you believe that clever fund managers can use their insights into future market volatility to determine when call options are over-valued and will then create net value by selling covered calls.

Whether these managers can price volatility better than the market as a whole or not, the basics of these funds mean that you should end up with a portfolio that is less volatile than a portfolio of the underlying stocks. This does not mean that these funds will be low risk or low volatility, however. If the stocks chosen for the portfolio are high Beta / high volatility stocks, then the portfolio may end up with high Beta and high volatility, even though the selling of covered calls should reduce total volatility.

When I took a basket of these covered-call CEF’s that have been around since at least the start of April, 2005 and looked at the volatility and Betas from April 1, 2005 through Jan 31, 2006 the results were striking:

SD is the standard deviation in annual return

Of all of these CEF’s that write covered calls, only MCN has standard deviation in annual return that is less than the S&P500. With the exception of FFA, all of these funds have Betas less than 100%. With the exception of MCN, all exhibit high levels of total volatility---much higher than the volatility of the S&P500.

While these funds can generate high ‘income’ streams, most are also generating a lot of volatility. This is especially notable given that the volatility in the S&P500 has been very low over this period. If we see the future volatility in the market as a whole revert towards its long-term levels, the volatility in these funds will increase dramatically. The pricing of options on QQQQ and SPY certainly suggest that we will see considerably higher volatility in the next couple of years than we have seen in the last couple. Most of these funds are likely to yield a very rocky ride in this environment.

There are many subtleties to how these funds will perform on an absolute and risk-adjusted basis. When you sell covered calls, you must choose the underlying assets and the strike prices at which you will sell the options. The higher the strike price, the less likely that the options will be exercised but options that are far out-of-the-money will be worth considerably less. The portfolio manager’s strategy for determining the strike prices at which to sell as well as other parameters of the option trading strategy will all impact the final features of the fund’s risk / return profile.

The bottom line seems to be that these funds have an awful lot of stuff going on that makes it very hard to judge their likely future risk and return. Whether or not you believe that managers can price volatility better than the market as a whole, evaluating the future prospects for these funds looks really hard.