A Better ETF Solution for Call-Writing Funds

In any month where the options expire in the money, they will be assigned and have to deliver cash equal to the amount they were in the money. Some months the options sold will be in the money and some months not. This is why the dividend paid by PBP will vary.

According to 10-year data from PowerShares, the Buy Write index has had a standard deviation of 10.8%, vs. 14.8% for the S&P 500, and a beta of 0.64 compared to 1.00 for the benchmark index. Buy Write's 10-year average annual return of 7.97% also beats SPX's average annual return of 6.57%.

Obviously, 10-year numbers include a skew for the tech bubble meltdown, but the five-year numbers are also compelling at 12.53% for Buy Write and 15.45% for SPX. Considering Buy Write's lower volatility, that's an excellent risk-adjusted return.

As I mentioned above, there are a number of closed-end funds, as well as a single ETN, the iPath CBOE S&P 500 Buy Write Index (BWV), that employ this strategy. Both types of investment vehicles have their limitations.

During times of market turmoil, prices of closed-end funds tend to fall faster than those of their holdings, as the accompanying chart of the (BEP)S&P Covered Call Fund (BEP) illustrates.

The fund's market price, as measured on the chart by BEP, has lagged its NAV per share by 10 percentage points. Factoring in the $2 paid in dividends (not captured in the chart), the total return of the fund's holdings would be 4.7%, but not so with the market price, which is what you pay. That is down 7.2% including the dividend.

The Downside It's rough when the going gets rough.

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The drawback for BWV is that as an ETN it doesn't pay dividends, and taking in option premiums (realized as dividend for fund holders) is a major attraction for the strategy. BWV still provides the total return, but just the same investors like dividends.

Notwithstanding these drawbacks, both the closed-end buy-wright funds and the ETN have benefits. There have been various period of time over the past few years when the closed-end funds have done very well, and the drawback to the ETN is more of perception than anything else.

PBP might mitigate these issues and while I hope it does, I would urge caution. I would like to the new ETF for clients, but I want to give it a few months to make sure it works as advertised. I am not expecting a problem but this is a strategy that needs to be executed in the ETF format and that has not been done yet. If there is a problem I would think it would be in how much needs to be paid when options sold expire in the money.

Lastly I would urge moderation. PBP potentially offers a panacea with close-to-market returns and much lower volatility. The closed-end buy-right funds offer the same promise, but have struggled periodically. In the last few years I have maintained a position in one buy-write fund at a time at about a 3% weighting. This is the type of concept that people get too enamored with and allocate too much to, only to regret it when there is some kind of market dislocation.

PBP offers the potential for low volatility with some yield. There are other, unrelated investment genres that offer the same attributes with little or no correlation to the fund. Blending two or three of these together in smaller percentages will be a much safer way to go.

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