David Merkel has post about chasing yield offered by investment products, specifically closed end funds, that is a must read. The tipping point for the article was an article from the Wall Street Journal that ran on Friday.
Both articles offer a little bit of caution and skepticism to consider for anyone considering a call writing fund, a dividend capture fund or a fund that does both.
I have written about these types of funds many times and even been quoted in a couple of places on this subject.
The notion that a glut of these funds could have an adverse impact on the markets they invest in or that something could go wrong internally, think large scale problem, is not that high, in my opinion, but is absolutely within the realm of possibility.
If you are going to use these types of funds you have to mitigate this issue for yourself. I think the easiest way to do this is to use these funds in moderation. I have disclosed many times that for clients who are a little more tolerant of volatility I weight the one call writing fund I use at 10% of the fixed income portfolio which works out to at most 4% of the overall account (think here about an account with 40% allocated to fixed income). For clients with a little less tolerance for volatility I think of these as being part of the equity portion and weight it at about 3% of that part of the portfolio.
I don't believe that any of the other fixed income segments would be truly damaged if something bad happened in the call writing segment. If the fund I use somehow blows up in a manner I cannot foresee the consequence would be a small lag which I think is acceptable. It would be unacceptable to me to have four different funds totaling 10% of the account when a blow up happens potentially causing some sympathy declines in other funds.
Part of the understanding here, and this is very simple to grab onto, is that if treasuries yield somewhere near 4.75%, there is risk in anything that yields more than treasuries (obviously you need to consider like maturities).
There is not a whole lot of recklessness in having exposure to investment grade corporate debt in the high fives or low sixes but a portfolio full of products that yield 8-9% in a 4.75% world is not a risk I would take for anyone.
A conservative way to look at this might be simply seek to add a few basis points to the overall mix. A $500,000 account allocated 70/30 with $15,000 (out of a possible $150,000 earmarked for fixed income) in a call writing fund will add some basis points overall without jeopardizing your financial future if you own the one fund that blows up.
Still this is not for everyone, that needs to be decided on first of course. I do view these funds as very useful but to repeat myself where these funds are concerned; moderation, moderation, moderation.
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11 comments:
one thing I don't think you've mentioned, is closed-end loan participation funds, which offer high (monthly) yield with no significant exposure to equities. Be interested in your comments.
Writing calls against blue chip dividend payers in a range bound market doesn't seem so outrageously risky. Interest rate risk and market risk are always there. Maintaining an underearned dividend over an extended period would seem to be the somewhat 'unique' risk to such a strategy. As a component within a properly structured portfolio, a buy/write strategy will work.
i have not really spent any time studying these funds, I perceive issues of loan quality, is that right?
I prefer adding yield in other ways but this could easily be another blind spot of mine.
tom c I am on board, just in moderation.
roger- everything in moderation.
Putting this post together with your next one Aussie/Swissie, it brings to mind my favorite gauge of market-sector sentiment: the premium/discount of sector CEFs. When they're at historically high permiums-beware. Doing a quick check of 3 call writing funds I find them all at premiums: ETY 1.5%, EXG 3.5%, and AOD 8.4%. All these funds are too new (another sign of froth... new funds come out when strategies are hot) to have real track records, but any sort of premium in a CEF is scary to me.
Moderation... no. Run away as fast as you can is more like it.
Tom C: Writing calls against blue chips is risky... if you buy in at a premium. First the stocks fall 5-10%... then people get a little scared, and start selling the CEF, and you end up at a 5-10% discount to NAV... Presto, the market is down 5-10%, but you're down 12-22%. Oops!
Tom Konrad- A buy/write strategy is inherently less risky than simply being long. If you are looking to immunize yourself from stock market risk, particularly the 'madness of crowds', stay away from stocks. Buying any CEF at a premium adds risk. Writing calls in a prudent fashion can, in fact, be used to generate additional income. Other factors relating to suitability and taxable events always need to be considered, of course.
Tom Konrad- A portfolio of higher quality, dividend paying stocks hedged with short calls provides additional income while protecting downside risk by the amount of the premiums earned from the short calls.
A CEF structured in such a fasion, trading near NAV should be similarly protected, assuming competent management. A 10% correction in the fund holdings will not reflect a 10% drop in NAV since the short calls will offset any drop to a degree. The premiums received for the short calls don't disappear but add 'balast' to the portfolio. Cash earned on the short option side can be put to work at lower prices and higher yields. Management track record seems to be the key determinant regarding risk/reward not the strategy itself.
Tom C& Anon: Point taken; I revise the numbers in my example above, so that a market dorp of 10 would only produce a 8% drop in NAV. In my example above to end "... down 10-20%" The CEF is still likely to be down more than the market as a whole.
And, if I'm right that the CEF premiums above are an indicator that there is too much interest in this strategy, the call-option premiums that the funds are earning are also likely to be historically low, and so the downside hedging you get from selling callis is likely to be proportionately reduced.
I still think it's silly to buy *any* CEFs at a premium. Wait 'til they're trading at a 5-10% discount (as most CEFs eventually do) and you'll have *real* downside protection. If you can't wait, you're chasing yeild, a.k.a. picking up nickels in front of a bulldozer.
If you really must use a covered call strategy when covered-call CEFs are at a premium, I suggest you get options level 0, and start writing your own covered calls on SPYders or DIAmonds or a basket of stocks you like.
Tom Konrad- If the CEF is trading at or below NAV with a good track record relative to varying conditions,i.e. a beta below 1, I don't see the risks you're talking about. If it's a fairly liquid fund and the dividend has been relatively secure during past market corrections, the risk profile improves even more. The yield on the CEF would further reduce risk. Proven management is the key. The strategy is sound. The yield on the SPY is, what, 1.75%? High yield blue chips can approach 3-4.5%.
Tom C: We're in agreement. You said "If the CEF is trading at or below NAV..." The closed-end funds I referenced are all trading above NAV, at 1.5% to 8.4% premiums.
I have no problem with option writing strategies; I use these strategies myself. I do have a problem with buying CEFs at a premium.
If the yeild on SPY is 1.74%, and you sell on the money call leaps (Mar 08 $144 calls are selling around $10.40), that gives you a net yeild of over 9%. If you get assigned, you then sell a cash covered put in Mar 08, and get a similar yeild (because your cash is probably earning 2+% in a money market fund.)
Tom Konrad- Exactly. I run money for different kinds of clients. Smaller ports use a particular fund that has a long track record of paying monthly divs annualise at about 8.5% cy. I've used the fund for a couple of years and watched it's NAV steadily grow over that period. It currently trades at par. The buy/write on the spiders works great and I use it occasionally. I've not been able to consistently match the performance of the CEF over time. Sometimes I do better sometimes not. Like I said, the strategy is sound when used properly. Buying at a premium ALWAYS adds to your risk it goes without saying.
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