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Covered Calls the Fund Way

Jennifer Openshaw

When you write a covered call against a stock you own, you sell the right to purchase your shares for a specified strike price at or before a specified future date. You collect a premium -- the price of the option -- for giving up this right.

And why? The main reason is to generate some current income. Those returns can be juicy -- 2% to 3% per month or more when things work out just right.

My point here isn't to give a full course on covered call writing; there are plenty of resources out there.

Instead, here's my issue. Covered call writing on individual stocks can be tricky. Getting good returns means using more volatile stocks, since option premiums are tied to volatility.

This is where a lot of investors run into trouble. Moreover, most of us just don't have the time or bandwidth, or don't want to put much risk capital into play this way. That's where covered call funds come in.

Covered call writing can be one of those areas where professional help and diversification make a lot of sense. Yet, somewhat to my surprise, only a few funds specialize in covered call strategies, and most toil in relative obscurity to the individual investor. So I want to help show the way.

Before going further, here's the main drawing card: Most of these funds pay a steady 8%-10% return, usually as a quarterly dividend. In today's environment of 4.5% money market yields and 5%-6% bond returns, that's not bad.

Most covered call funds are so-called closed-end funds, which sell a fixed number of shares that trade on an open market.

Click here for the video version of this story from Jennifer Openshaw.

For this strategy, closed-end funds work best, because the fund manager can fully deploy assets and not worry about redemptions. And investors don't have to worry about sales charges, though they might pay a small premium to the fund's net asset value.

Here's a look at some of the choices:

• Index covered call closed-end funds

  Funds sell covered calls not against stocks but against the S&P 500 index. The result is good income with downside risk matching overall market risk. The S&P 500 Covered Call Fund (BEP Quote) is the largest player.

• Stock covered call closed-end funds

  These funds sell calls against individual securities owned in the portfolio. These securities can cover the market or target specific sectors, and some blend in international stocks. The portfolio percentage put into play with covered calls may vary as well. These pay somewhat more than index covered call funds.

  The biggest players include Madison Claymore Covered Call Fund (MCN Quote), First Trust Fiduciary Asset Management Covered Call Fund (FFA Quote) and the ING Global Equity and Premium Opportunity Fund (IGD Quote), which adds an international flavor.

• Open-ended funds

  As ordinary mutual funds, in the face of competition, seek higher returns, covered call writing is coming back into vogue. Last summer's launch of the (VEPAX Quote)Van Kampen Equity Premium Income Fund (VEPAX) may be one of the purer plays in this space, but the 5.75% upfront load gives me pause.

I believe closed-end funds are worth a look, especially for a portion of a well-diversified portfolio. During my research, I was particularly drawn to the Madison Claymore Covered Call Fund, which offered by far the most consumer-friendly online information and a very helpful toll-free information line.

As I investigated Madison Claymore, it dawned on me that if funds aren't quite your thing, you could even play a little "follow the leader" and mimic some of their strategies and holdings.

Madison Claymore gives an up-to-date list of its top 10 holdings. You could buy Biogen Idec (BIIB Quote) for $49.50 and write a month-out covered $50 call for $1.65 -- an implied 4% monthly return -- or do a similar move for Best Buy (BBY Quote) or eBay (EBAY Quote). You'd take on the risk of owning the individual stock, but at least you'd have the comfort of knowing the pros are doing something similar.

However you decide to approach it, enhancing current portfolio income with covered calls is a relatively low-risk strategy if done carefully. Covered call funds are a good way to get started.