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The market malaise is causing angst among the many fund managers who are rewarded for beating the S&P 500. And as stocks remain range-bound, it's growing tougher for them to prove their worth without adding extra risk to their portfolios.

But there is one set of mutual fund skippers cheering the market's shiftlessness: those managing covered-call funds. Two of the four major covered-call funds are beating the S&P 500, with the category giant

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Gateway Fund up 2.35% year to date vs. 1.3% for the S&P. And the managers of the remaining two funds fully expect to beat the benchmark by year's end.

"We don't generally advocate investors buying funds based on short-term trends, but covered-call funds generally do well when stocks are standing relatively still," says David Kathman, analyst at fund-tracker Morningstar. "That's because investors can simply pocket the income if the call does not get exercised and the stocks maintain their value."

Covered-call writing is a popular though somewhat complicated options strategy in which you sell a call option for a premium against shares that you already own. The buyer of the call option keeps the gain if the stock rises above a certain level (called the strike price) by the time the option contract expires.

If the stock price exceeds the strike price at the end of the contract, then the stock is sold. If, however, the stock fails to reach the strike price by the end of the life of the contract, then, as Kathman points out, the investor keeps both the premium and the stock. It's a win-win situation, provided the stocks continue to flatline.

Gateway's Way

The oldest and by far the largest covered-call fund is the Gateway Fund. The $1.78 billion fund was founded in 1988 by Walter Sall and is -- as one competitor calls it -- "the 1,000-pound gorilla in the category."

Gateway's strategy is to buy all the component stocks in the S&P 500 index and then sell index call options against them to generate income for the fund. To provide additional safety for fund holders, Gateway portfolio manager Patrick Rogers, a partner of Sall's who manages the fund on a day-to-day basis, uses the call premiums to purchase out-of-the-money put options (or put options with strike prices below the market level) on the S&P 500 index.

A put option gives the holder the right to sell an asset at a certain price within a specific period of time. Put options increase in value when market prices fall, therefore put-buyers gain some measure of safety against a sharp drop in prices.

Harry Merriken, a partner at Gateway, says the fund typically makes 20% annually on call premiums, but its put strategy as well as trading costs cost it 8%. The result is an expected 12% return in a normal market environment.

Unfortunately, normal market years are hard to come by, and that explains why the fund's average annual return is 9.3% since it was founded. Not that there's anything wrong with that. Most investors would jump at the opportunity for steady junk bond-like returns in a fund with a beta of just .38.

Beta is a measure of volatility, or systematic risk, of a stock or fund in comparison with the market as a whole. A beta of less than 1 means the fund is less volatile than the market. So for example, if the market goes down 100%, then the Gateway Fund would fall only 38%.

But on the flip side, if the S&P 500 were to skyrocket as it did in 2003, then low beta funds like Gateway leave a lot of upside on the table. Last year, the S&P rallied 28.7% while Gateway only rose 11.6%. (Fees for the fund are 1%, below average for a stock fund.)

Once again, not bad, but not for investors looking for a thrill -- or income. Unlike some other covered-call funds, Gateway is a total return fund and pays out only a minor dividend. Last year the fund yielded shareholders 0.72%.

But that's not dissuading investors from piling into the fund as of late. According to Merriken, the fund is seeing heavy inflows from investors seeking shelter from a trendless stock market as well as a "low-volatility investment not correlated to interest rates."

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Bridgeway, Dobson & Kelmoore

Gateway's three largest competitors combined don't reach a third of Gateway's market capitalization, but they do offer some interesting variations on the covered-call strategy.

Unlike Gateway's Rogers, Richard Cancelmo, portfolio manager for the $21 million

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Bridgeway fund, prefers to sell puts in his fund instead of buying them. In fact, 30% of the Bridgeway fund is composed of puts sold on large-cap names such as

Gap Inc.

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Progressive Corp.

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. Cancelmo sells the puts to generate premium and chooses the names using a quantitative model so he "does not have to have an opinion on the market."

As collateral for the put sales, the fund keeps 25% of its assets in Treasury bonds bought at auction -- to keep expenses down, according to Cancelmo. As with Gateway, the expense ratio for the fund is close to 1%, a price that seems reasonable for a stock fund with bond fund tendencies.

Charles Dobson, portfolio manager of the $6 million


Dobson Covered Call fund, says "the last five years, the S&P has not done anything, and we are expecting the same over the next five years." Dobson's fund has beaten the S&P for the past five years on an annualized basis, even though his fund is up 0.95% year to date, slightly trailing the S&P 500.

Dobson says he runs a "quasi-index fund," on the basis of S&P 500 selling covered calls against large-cap names such as


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(IBM) - Get International Business Machines Corporation Report

. Dobson's fund is a straight covered-call fund, no put-buying or selling allowed.

Dobson maintains a beta for his fund at 0.7, higher than Gateway and Bridgeway, but not really opening up the throttle on what he sees as a low-volatility investment.

"It should be part of everybody's asset allocation as a way to reduce volatility. And if you reduce volatility, you will make money," says Dobson.

The $243 million


Kelmoore Strategy C fund not only has the highest beta of the group at 0.9, it also offers the highest dividend yield, at 10.81%. (It also has the highest expense ratio at 2.1%, due to the fund's heavy reliance on trading.)

Matt Kelmon, portfolio manager of the fund, says the fund is targeted toward tax-deferred accounts, since it is constantly returning the option premium to investors in the form of a dividend. He says this strategy is perfect in a rising interest rate environment when "bonds are vulnerable and the market is not going anywhere."

Kelmon predicts investors will continue to see stocks trade in a tight range. He offers software giant


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as an example.

"Microsoft has barely budged over the past three years, and we expect it to continue that way," says Kelmon. "We love it."