Market Watch: Funds Use Options to Enhance Income
By Reshma Kapadia
At a time when investors are caught between meager interest rates on savings accounts and worries about whether the recent stock-market run-up can continue, funds using options to generate extra income or cushion against losses, or both, are gaining attention.
One of the most popular approaches involves “covered calls,” a strategy in which an investor—in this case a fund—generates extra income by selling to another investor the right to buy some of its stock holdings at a set price, if the shares rise above that price by a set date. In essence, the fund is getting more dollars today in exchange for giving up potential gains down the road. Other options may be used simultaneously to limit downside risk.
“We think the [stock] market has experienced most of the gain for the year already and is probably going to see more volatility, so this strategy makes a lot more sense at this point” than in some other environments, says Tyler Vernon , chief investment officer of Biltmore Capital Advisors, Princeton, N.J., which has $600 million under management.
The Chicago Board Options Exchange’s CBOE S&P 500 BuyWrite index, which tracks covered calls, outperformed the Standard & Poor’s 500-stock index over the decade through March, with annualized returns of 3.5% versus 3.4%. And the S&P 500 had 30% more volatility than the CBOE index.
“Covered-call writing is always less risky than outright stock ownership,” says Dick Cancelmo , manager of Bridgeway Managed Volatility /quotes/zigman/291455 BRBPX -0.26% , a fund that uses options. “How much less depends on how aggressive or conservative is the strategy.”
A covered-call strategy typically works best when the market is rising gradually or relatively flat, so the income collected from the option sale exceeds any potential gains that may be forfeited.
If the stock against which a call is written doesn’t rise above the strike price by the agreed-upon date, the fund pockets the extra income from the option sale and gets to hang on to the shares, too. If the stock rises above the price within the agreed-upon time, the fund hands over the stock to the option buyer, forfeiting any future gains, but gets to keep the income from the option sale. Of course, if the stock plummets, the fund is left holding the stock—and the loss—although it is reduced somewhat by the income generated from the option sale.
The highest premiums from selling covered calls typically come from owning the most volatile stocks. “Because you have full exposure to the downside and are capping the upside, you have to be careful to buy high-quality businesses,” says Zeke Ashton , who manages Tilson Dividend /quotes/zigman/378692 TILDX -0.07% .
Options come with their share of risk, so analysts urge investors to stick with fund managers who have a good track record using them and caution against being wooed by high yields without digging deeper.
Not every fund manager uses the same options strategy. Some sell covered calls on a broad index, while others write them on individual stocks, which can be riskier. Others buy put options, or the right to sell, in conjunction with the covered calls to reduce the risk from a market decline.
Here is a look at some funds using covered calls:
Gateway /quotes/zigman/227304 GATEX -0.30% , which owns a basket of stocks that resembles the S&P 500, is one of the longest-running funds using covered calls to generate income and put options to cushion the downside. Gateway sticks with index calls and puts, rather than selling and buying options on individual stocks. At any given time, the managers may not be completely hedged on the downside if the puts, which essentially act as insurance, are too expensive. The fund has beaten the S&P 500 over the past decade, with less volatility. But Nadia Papagiannis , alternatives analyst at Morningstar Inc., says Gateway in the past year “has not shone as bright as in the past,” in part because it hasn’t excelled at capturing the market’s recent upside. Over the last three years, it has returned an average of 0.53% annually, putting it in the top half of its long-short category.
Bridgeway Managed Volatility uses its quantitative models to create a basket of stocks designed to mimic the S&P 500. Mr. Cancelmo, who has worked with options since the 1980s, uses them in this fund primarily to reduce risk. He sells covered calls or secured puts, another strategy to achieve the same goal, against the index-like portion of the fund. The fund holds at least a quarter of its assets in high-quality bonds, helping minimize volatility further. While Morningstar says Bridgeway’s quantitative models have been bumpy lately, Mr. Cancelmo says the fund has beaten the S&P 500 since its inception in 2001 with 55% less risk. Over the past three years, it averaged a 1.7% return annually, beating 70% of the long-short funds with which Morningstar groups it.
Seeking More Juice
Neiman Large Cap Value /quotes/zigman/346789 NEIMX -0.40% owns mostly dividend-paying stocks. It sells covered calls on the individual stocks, handing over the rights to the stock typically after the company pays at least one quarterly dividend. “On average, we are collecting about 2% annualized from the dividend and then we feel we can often double that rate of return with the option,” says fund manager Harvey Neiman . While Mr. Neiman sells covered calls on all of the fund’s stocks, he doesn’t necessarily sell the right to the full amount of any one holding. “If we get a raging bull market, you want some of the upside,” he says. The fund returned an average of 1.41% a year over the last three years, putting it in the top half of large-cap value funds.
Aston/M.D. Sass Enhanced Equity /quotes/zigman/496328 AMBEX -0.11% holds just 35 to 40 large-cap value companies and sells covered calls against every holding—often with expiration dates that are six months out, which is longer than the average one to two months. The fund’s manager, Ron Altman , says that typically enables him to pocket a larger share of the stock’s potential upside and help meet the fund’s objective of generating cash flow from the calls plus dividends of 10% or more a year. Mr. Altman says he will occasionally buy puts as “catastrophe insurance,” but only when they are cheap. Over the past three years, the fund has averaged a 2.84% return annually, putting it in the top quarter of long-short funds.
Some funds take their cues from the market and don’t always opt for the insurance of put options.
Schooner Fund /quotes/zigman/523065 SCNAX -0.31% buys large-cap stocks and often sells covered calls against them. It also occasionally uses put options against an index like the S&P 500, but only when protection is cheap, which usually means buying puts when the market is flat or climbing. As much as half of the fund’s assets can be invested in fixed income. “Some funds may be bad at doing it tactically, but Schooner has done well so far,” Ms. Papagiannis says.
Tilson Dividend also takes a more tactical approach. The fund tries to combine decently paying dividend stocks with covered calls to generate income. Mr. Ashton, the fund manager, says he doesn’t sell covered calls on every stock in the portfolio and occasionally owns non-dividend-paying stocks for their upside potential.
In general, he says the covered-call strategy allows him to stick with strong high-quality companies to generate the income investors expect, rather than seek out higher-yielding firms with weaker balance sheets. Over the past three years, the fund has averaged a 13.74% return, putting it in the top 1% of the midcap blend category, according to Morningstar.