A Better ETF Solution for Call-Writing Funds

The recent listing of the PowerShares S&P 500 Buy Write Portfolio (PBP Quote) reminded me of how much of a nerd I am -- who else could get excited about the launch of another call-writing fund?

The reason I'm so thrilled is that, while call-writing strategies have been available for a while through closed-end funds and more recently through an exchange-traded note, this is the first time one has been offered through an exchange-traded fund.

PBP has the potential to overcome some of the downside to investing in a "buy-write" strategy through those other investment vehicles.

Buy write is a strategy that involves buying a stock and selling call options, which are rights to buy that stock at a predetermined price. The upside can be smoother returns, as the income generated by selling call options can help offset declines in any portfolio holdings. This is especially helpful in a down or flat market.

The downside is that the strategy should lag when the market is up a lot and you are forced to sell stocks at below-market prices. For example the CBOE Buy Write Index (BXM), which is PBP's benchmark, lagged the S&P 500 by 9% in 2003.

A Smoother Ride A strategy's advantages

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The chart above demonstrates why there is so much interest in the call writing space, and why there are over 20 closed-end funds that employ the strategy. The correlation between BXM and options on the S&P 500 index is tight most of the time -- 0.87 according to PowerShares -- but in times of market stress the ride can be smoothed out very nicely.

PBP will own the stocks in the S&P 500 and sell at-the-money call options every month, charging 0.75% for the privilege. It will pay a dividend, but because options premium can change over time, the dividend available to shareholders will vary.

The potential dividend needs to be deconstructed a little to understand what holders may or may not be getting. PBP will hold the stocks in the S&P 500, so PBP holders will get that dividend. Additionally there will be call premium. According to PowerShares, the option writing averaged a little over 1% per month in premium. So you might be thinking PBP will yield 14%.

Not so fast my friend.