Exchange-Traded Notes Cool the Volatility

The way to look at BWV, I believe, is as a tool to reduce volatility within a portfolio. There may also be a tax advantage. After reading the prospectus and scratching my head, I was able to find this from IndexUniverse.com: "BGI believes that, under current tax law, ETNs should be treated as 'prepaid contracts.' If that's the case, the funds will never pay distributions, and shareholders will only owe taxes when they sell the fund."

It is possible that this status could face an unfavorable ruling from the IRS that could make them less tax-friendly, meaning taxes could be owed even if you have not sold. If you have an interest in BWV and have an IRA or other tax-deferred account, it makes sense to put it in that account.

BuyWrite vs. Closed-End Fund

So with the disclaimer and boilerplate out of the way, should anyone buy the fund, or are the closed-end funds a better way to go?

I think that the closed end funds, although less volatile than the market, will be more volatile than BWV.

Click here for larger image.

This chart compares the BuyWrite index (BXM) with the market price (BEP) and the net asset value (XBEPX) of the S&P 500 Covered Call Fund (BEP - commentary - Cramer's Take), which I believe comes the closest of all the call-writing CEFs to mimicking BXM.

The net asset value, although distorted on the chart because of its twice-yearly dividend, does track BXM quite closely, but the market price has had lower lows and higher highs as the fund has swung from a discount to NAV to its current premium of 10% after having had a premium as high as 25%.

There have been other CEFs that have swung from discount to premiums, and while gaming what comes next for this aspect of the space is very difficult, one thing is clear: It does create visibility for the CEFs to be more volatile than the ETN product.

One last point is about expectations for results. I would expect BWV to do well vs. the S&P 500 most of the time, except for when the market is up a lot; with a lot being defined as more than 20% in a year. In 2003, when the S&P 500 was up 26%, the CBOE BuyWrite Index was only up 17%.

I am favorably disposed to the idea and inclined to think BWV will have a place in a diversified portfolio. In past articles, I have talked about allocating 3%-4% of a portfolio into call-writing funds. A possible strategy would be to split between BWV and the CEF of your choice, with 2% going into each. The drawback would be less yield, and the benefit, as I see it, would be much less volatility.

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At the time of publication, Nusbaum had no positions in the stocks mentioned, but Barclays is a client holding, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.