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February 1, 2012

BuyWrite Bounceback

Mutual Funds Using Covered Calls Make a Comeback

By Peter Chapman

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After three years of near dormancy, mutual funds using covered calls showed signs of life last year. That's despite evidence of investor dissatisfaction with fund companies.

Two new closed-end funds that cover at least half of their stock holdings with call options -one from Gabelli and the other from John Hancock-launched in 2011.That brought the total number of closed-end funds classified as buy-write funds to 31, according to Morningstar. It also added about $600 million in net assets to the group, increasing the total to about $21 billion.

Cara Esser

The new funds are the GAMCO Natural Resources, Gold & Income Trust by Gabelli and the John Hancock Hedged Equity & Income Fund. They represent a resurgence of sorts for an investment category that had lain moribund since 2007. The fund group emerged in 2004 in response to investor frustration over low fixed income yields. Because sellers of calls receive premiums, distributions from buy-write funds were touted as a solution to the yield problem. Between 2004 and 2007, at least 30 closed-end buy-write funds-those that cover at least half of their assets with calls-launched.

Then, after the financial turmoil of 2007 and 2008, the strategy largely vanished. Net assets declined by about one-third.

Most buy-write funds are closed-end. They issue shares, invest the proceeds and close up. Unlike exchange-traded funds and open-ended funds, they do not issue new shares nor redeem old ones. Yet like ETFs, they trade on exchanges. The biggest managers of these funds are Eaton Vance, BlackRock and Nuveen.

Investor satisfaction or dissatisfaction with the funds is seen in the performance of their stocks. Last year, investors were very dissatisfied. Data from Morningstar shows the market capitalization of the funds declining by 16 percent from $20 billion to $17 billion. That compares with a decline of 7 percent for all stock-holding closed-end funds and a flat S&P 500 Index.

Behind the selloff may be investor skepticism over yield claims. In the early days, many of the funds promised high single-digit or low double-digit yields. Those numbers proved too lofty, and required a return of investor capital to maintain. Some fund managers, notably Eaton Vance, cut their distribution rates. "People are wary of an equity fund that has a 10 percent distribution rate," Morningstar analyst Cara Esser, says. "It's just not sustainable in this kind of market."

The buy-write strategy is still popular with retail investors however. Thom Severson, who runs the $150 million Theta Growth covered call fund for Capstone Asset Management Company, reports strong demand, partly because of investor disenchantment with the closed-end funds. "We have seen a huge uptick in retail," Severson said, "especially in the $300,000 to $700,000 separately managed accounts."