Buy-Write Strategy Gets Another Look

After three years of near dormancy, mutual funds using covered calls showed signs of life last year. That’s despite signs 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 Funds 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 kitty to about $21 billion.

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 as a response to investor frustration with low yields in fixed income markets. 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 without a trace. The market rout of 2008 subtracted about one-third of the total net assets from the funds, the value of which is only now recovering.

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 through stock performance. Last year, investors were very dissatisfied. According to data from Morningstar, the market capitalization of the funds declined 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. A 10 percent distribution rate is pretty high for an equity fund."

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 for his services, 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."

The portfolio manager explains many individuals are switching to covered call investments from fixed income investments.

Also, problems in maintaining distributions at closed-end funds have driven money his way. "A lot of the closed-end funds have failed in the past 18 months, he noted, "so you see some money flowing to us from closed-end funds that haven’t worked out correctly."

Open-ended buy-write funds have problems delivering on their promises as well. Invesco’s PowerShares S&P 500 BuyWrite Portfolio, manages about $120 million in S&P 500 stocks. Its performance is benchmarked against the Chicago Board Options Exchange’s S&P 500 BuyWrite Index.

Despite the passive nature of the fund, Invesco still managed to underperform its benchmark in its most recent fiscal year.  The CBOE index returned 8.8 percent in the year ended April 30, 2011. The Invesco fund returned 7.8 percent. Fund managers, in their annual report, blamed "relatively wide option bid-ask spreads" for the gap.

Esser says the buy-write strategy is still kicking, but future closed-end funds will likely write calls against a smaller portion of their assets.

"We see more funds launching with an option to do covered calls against perhaps 20 percent to 30 percent of the portfolio," she said. "That is, funds that just do a little bit of it here and there to generate extra income. But they don’t have to do it. It’s not the portfolio’s underlying strategy."

Indeed, BlackRock is doing just that. The money manager launched a huge $840 million closed-end fund called the BlackRock Resources & Commodities Strategy Trust last year. In its semi-annual report, it stated it had written covered calls against 9.6 percent of the stocks in its portfolio.