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 Quote), 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)

Source: BigCharts.com

Fortunately for my clients, the Madison Claymore Covered Call Fund delivered as hoped: some correlation to the S&P 500 and much less sensitivity to swings in interest rates.

The big criticism is that when the stock market is up a lot, these funds will lag badly. I believe that is exactly right. Wouldn't a bond or a bond fund badly lag an up market, too?

Remember, being diversified means not having just growth names or low-beta names but a blend of investments serving different purposes.

When buying any stock-based product, it makes sense to analyze the holdings to see what sectors it is invested in to avoid being too concentrated in any one area.

This doesn't necessarily apply to call-writing CEFs.

Madison Claymore has heavy exposure to technology (14%) and financials (17%), yet as the chart below shows, it has almost no correlation to the tech sector and at times appears to have a negative correlation to the financial sector.

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)

Source: BigCharts.com

Madison Claymore has about a 3% weighting in client portfolios.

While most of these funds are quite similar, I know this one better than the others. Over the last year, MCN has traded at a narrow (less than 5%) premium to its NAV. Recently, the premium spiked up to 6%, but it is now back below 5%. Madison Claymore yields 8.6% and currently is not using leverage.

Most of the funds that have been issued in this category in the last year offer nothing new. One positive exception is the ING Global Equity Dividend Premium Fund(IGD Quote). The fund invests primarily in foreign companies, and most of the stocks held yield 3% or more. The managers of the fund will sell calls on 50% to 100% of the portfolio. It yields 9.38%, but because the dividend yield is targeted at 3%, only 6.38% is coming from call-writing. This is a general observation as the dividend component is subject to fluctuation.