Call-Writing Funds a Shelter in a Storm
This column was originally published on RealMoney on Sept. 26 at 8:14 a.m. EST. It's being republished as a bonus for TheStreet.com readers.
The right type of diversified portfolio can be thought of as a comfortable mix of hot potatoes and steady Eddies. I'm expecting 2006 will be a rough year for domestic equities, so I think it will make sense to have a heavier weighting than normal in steady Eddies.
This is a role that call-writing closed-end funds, or CEFs, can play.
One of the most popular categories of new products this year, call-writing CEFs buy stock and sell either covered calls or index options (calls and puts) to generate income.I am aware of about 20 of these, but I'm sure there are more. I learned about them last fall in an article by Steven Smith on TheStreet.com, and I have been investing in them for client portfolios. My initial reaction to these funds was that they would take on positive characteristics of both stock and bond funds. I expected there would be some correlation between these funds and the broader market, but that the CEFs would have much less volatility in both directions. While these funds do own equities, I expected the calls sold to limit the upside and cushion the downside. Obviously, this is the idea behind a covered-call strategy, but these types of funds could draw more interest from investors at different points in the stock market cycle, causing the premium to increase, thus providing more cushion when stocks go down. I also expected these funds to act like bond funds in that they yield a steady 6%-8%. However, because the funds do own stocks, they should have less interest rate-sensitivity than most bond funds. If the next big move in interest rates is in fact up, call-writing CEFs could be all the more compelling. The following chart compares one of the first call-writing CEFs, the Madison Claymore Covered Call Fund (MCN), to the S&P 500 index and the CBOE 10-Year Treasury Index (TNX).
|Compared to Stocks and Bonds
The Madison Claymore Covered Call Fund (MCN) has had some correlation to the S&P 500 but has been less interest rate-sensitive than 10-year bonds (TNX)
|Correlation to Tech and Financials
Despite being heavily invested in the tech and financial sectors, Madison Claymore's performance has not tracked them
(The tech sector is represented by the SPDR XLK; financials by the SPDR XLF)
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