Covered Calls for the Long Run - TheStreet

In a low-implied-volatility environment, writing covered calls is a highly effective investment strategy. As a follow-up to

Friday's piece about writing covered calls on individual issues and specific stocks, today I'll focus on some of the products available for investing in a broad market, covered-call strategy.

Covered-call writing received a huge boost last July when Chicago-based research firm Ibbotson Associates published a study on

passive investment strategies. The study had a particular focus on the buy-write strategy based on the Chicago Board of Option Exchange's BuyWrite Index (BXM). The BXM is a passive or mechanical investment strategy based on selling near-term, near-the-money

S&P 500

calls against the underlying index. The call is held until expiration, with a new one-month call being written on the third Friday or expiration of each month.

Sitting on a Benchmark

The study showed that over the past 15 years, the BXM has delivered a compounded annualized return of 12.39%, slightly better than the SPX's 12.20%, but with 34% less volatility or market risk. As a purely passive investment program, it has produced superior returns while simultaneously reducing the risk by one-third. As of Monday's close, the BXM is up 1.7% year to date, while the S&P 500 is up just 0.04%. One drawback of covered-call strategy is that it greatly reduces the upside potential; in those years that the SPX has gained more than 18%, the BXM has underperfomed by an average of 6.5% per year. But this has been more than offset over time, as the BXM outperforms the SPX during down or flat years.

The BXM's outperformance highlights the fact that many times a successful investment strategy rests on the discipline of not deviating from the defined program. Unfortunately, both professionals and individuals often let emotion and short-term action lead them astray. This may come in the form of adjusting strikes and expirations or using puts to offset existing positions. A general notion in options trading is that adjustments are usually made for defensive reasons, and they convolute the initial investment thesis. The important point is that the BXM, or any other long-term, buy-write program, sticks with the strategy regardless of current implied volatility.

To be fair, it's important to note that the BXM's returns do not include any fees or transaction costs, both of which can be quite high for active funds, which must roll option positions on a monthly basis. As a frictionless or cost-free index, the BXM has about 1.5% per-year performance advantage over a real-world replication.

More Choice, More Decisions

Individuals can always try to replicate the BXM or covered-call strategy on their own by using

S&P 500 Trust

(SPY) - Get Report

and its related options, for example. But costs in terms of both time and fees might result in inferior returns. It might be wise to consider some professionally managed funds. Just three years ago there were less than a handful of funds that fell into "covered-call" category, but there has been a veritable surge over the last year. Expanded choices mean one has to do more homework to understand the true cost and nature of each product, in order to determine which best meets your objectives.

A few longstanding covered-call funds include the

(GATEX) - Get Report

Gateway Covered Call fund, the

(BRBPX) - Get Report

Bridgeway Balanced fund and the


Kelmoore Liberty fund. Each uses covered calls to a varying degree, but none tries to mimic the BXM. In fact, there are important distinctions, such as dividend distributions and focus of investments. Examples of deviations include the fact that Bridgeway keeps 25% of assets in fixed income, and the Kelmoore fund holds many tech names that may not be part of the S&P 500.

Recently, the CBOE has been aggressively marketing the BXM as a licensed benchmark, and that has spawned some new investment products. Shortly after the Ibbotson study was published, two closed-end funds benchmarked to the BXM were launched and met with great demand. The

Madison Claymore Covered Call Fund

(MCN) - Get Report

fund raised $260 million, and in August, the

First Trust/Fiduciary Asset Management Covered Call Fund

(FFA) - Get Report

fund raised $338 million. These are closed-end funds, meaning they will not be accepting new investors or even new money from existing investors. But one can buy (and sell) stakes in their publicly-traded shares.

In another sign of the continued, growing interest in such funds, Eaton Vance raised a whopping $875 million in January for its closed-end

Enhanced Equity Income Fund

(EOS) - Get Report

, which will write covered calls "on a substantial portion of the portfolio," according to the prospectus.

The advantage of a closed-end fund is that it typically pays out a higher dividend. The disadvantage is that it can have higher costs than many traditional mutual funds; Madison Claymore charges an annual fee of 1% and First Trust's fee is 1.22% of assets under management, which is on top of transaction costs. Also be aware that the funds, due to the limited shares available, can trade at premium to their actual net asset value, leaving holders vulnerable to a sudden price discount.

Still, it's important to understand that nearly all covered-call funds (or those that use put options for either income or protection) retain discretion for the fund manager to adjust the beta or net exposure of the position. For example, Frank Burgess, the portfolio manager for the Madison Claymore fund, says he will sell calls against roughly 80% of the fund's holdings at any given time."

The Bridgeway fund writes calls against only 10% of the total portfolio at one time but will sell puts to establish new long positions or create bullish exposure in individual issues. "Implied volatilities help us identify which are the best options to sell regarding strike and expiration but are not part of the stock selection screening process," says fund manager Richard Cancelmo. By comparison, Kelmoore searches for high-volatility situations in which to write options and also writes puts as a means of establishing a long position.

Dividend distribution will also be an important consideration in determining which product will best help meet your investment goals. The BXM is calculated on dividends being reinvested; some funds such as Bridgeway also reinvest, while others pay out a healthy dividend.

If you want to take the manager's discretion out of the equation, consider the

Morgan Stanley Strategic Total Return Securities


fund. This is an exchange-traded fund (ETF) whose value is based on the daily closing price of the CBOE's BXM BuyWrite Index. The securities were issued last November at a price of $10 per unit and have a maturity date of Dec. 17, 2009.

Although recent listing of SPY options makes it relatively easy for an individual to replicate the BXM, this is still a fairly labor-intensive process in which emotions can easily lead you astray. So unless your transaction costs are low and your disposition is aligned for a long-term investment horizon, it may be better to let a professional manage the portion of your assets designated for a covered call program.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to