Given the recent volatility of the stock market, who wouldn't relish the opportunity to capture the next big upswing with a "call" option to buy shares at specified prices at some future date?
Conversely, it's pretty tempting to hedge against another major downdraft with a "put" option to sell shares at a specified price.
Puts and calls are extremely risky by nature and are usually not recommended for inexperienced investors. However, there are a number of fund managers who juice the returns of their portfolios -- and buffer them against market declines -- using puts and call. Not by buying them, but by "writing," or creating them and selling them.
Some funds also
put options to enhance returns, which is a conservative strategy, relatively speaking.
These kinds of strategies are more typical of closed-end funds, but there are also a number of open-end mutual funds that employ them. They are known as option-income funds.
The call options issued by these funds are "covered," in that the funds already hold the shares; otherwise they would be considered to be "naked" -- meaning the funds might be subject to outsized losses.
The proceeds from the sale of covered call options can enhance the incomes of funds. The income can also soften the impact of price declines in the underlying securities.
Even in a flat to modestly upward market, the sale of covered calls is profitable if the price level of the underlying stocks does not exceed an option's exercise price. In such cases, the options expire worthless and each call option's "premium" -- or price tag -- remains with the selling fund.
Option-income funds are most appropriate for tax-deferred investment accounts, as profits from option premium sales are taxed as ordinary income. By comparison, most regular dividend income currently enjoys preferential tax treatment.
The downside to this kind of "padding" of performance is that when stock prices are rising rapidly, investors can exercise their option to "call" -- meaning buy - the securities from the option income fund at below-market prices, thereby truncating the fund's potential portfolio gains.
Likewise, selling "put" options, or contracts that allow their holders to sell stocks at specified prices for limited periods of time, can either pad a fund's performance or truncate its gains.
In the event of a price decline, the holder can buy the stock at the prevailing low price and sell it to the fund at the higher price specified in the "put" contract.
The accompanying table lists open-end mutual funds with stated investment objectives of using covered calls or put options.
Since writing calls is supposed to "cushion" a portfolio during declines, the table includes performance for calendar year 2002, the most recent bear-market year. This demonstrates whether the funds truly insulated shareholders from the 22.10% drop in the
The three funds at the top of the list all survived 2002 with significantly less damaged than the S&P 500.
Moreover, the volatility of each of the three over the past three years, as measured by its beta coefficient, is lower than that of the S&P 500. The beta is a gauge of a fund's historic volatility relative to "the market" (frequently defined as the S&P). For example, a fund with a beta of 0.50 will be expected to decline only 5% when the market sinks 10%.
But the other side of the coin is that a fund with a beta of 0.50 will be expected to advance only 5% when the overall market jumps higher by 10%.
For each of the three funds in the top grouping on the list, the low beta coefficient translated into returns that lagged the S&P 500 during the recent periods of advancing stock prices. Even with their muted performance in recent years, subdued levels of volatility helped earn them each grades from TheStreet.com Ratings in the "C" range, which equates with "hold" recommendations.
Of the three funds in the top section of the table, the
Bridgeway Balance Fund (BRBPX) and the
Gateway Fund (GATEX) include in their descriptions that they use "put" options as well as covered calls.
The Bridgeway Balanced Fund's top holdings are
Briston Myers Squibb
. The Gatway Funds biggest investment holdings are
The third member of that group, the
TCW Dividend Focused Fund (TGIGX), is the least committed of any in the table to covered call writing. Its description includes the tentative wording: "The fund may also invest some of its assets on covered call options."
This modest commitment to covered options is reflected in the fact that its beta coefficient is higher than any other fund on the list. The TCW Focused Fund's largest holdings are
The second grouping from the top of the table includes three funds that debuted after the start of 2002. Thus their performance histories are insufficient to confirm that their option strategies might provide buffers during market downturns.
Each of the trio of funds near the bottom of the table has stated objectives of writing covered call options. However, each tumbled more than the S&P in 2002, leaving some doubt about their ability to provide some insulation against bear markets. Each receives marks in the lowest possible "E" range from TheStreet.com Ratings, making them "sell" recommendations.
The bottom fund on the list survived 2002 with minimal damage but has produced negative returns in recent months. This recent performance earns it a grade of "E" and a sell recommendation from TheStreet.com Ratings.
Because of their structure, open-end option income funds face a unique hurdle in writing options on their portfolio holdings. They run the risk that fund redemptions by their shareholders might force liquidation of the stocks underlying the options. This would disrupt the balance of options and underlying securities that provide hedges against outsized losses during periods of unusual market volatility.
Closed-end funds, which issue a fixed number of shares that trade on an exchange, are better suited to use option-income strategies than their open-end counterparts, and many do so successfully.
The downside to investing in closed-end option-income funds is that they can trade at a discount to their net asset value for painfully long periods of time. That means shareholders who want to sell them may have to leave some of their money on the table.
Richard Widows is a financial analyst for TheStreet.com Ratings. Prior to joining TheStreet.com, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.