Reader Question 2

In an ongoing thread there was a question about covered call funds. I used to write about these more. I am a believer in the concept but many of the CEFs have done poorly through the market events of the last year. I have used one CEF (with foreign exposure) for many clients with a very small weight (this is the manner in which I wrote about how to use them; in moderation).

Specifically the reader seems to be asking whether holding a call writing fund in lieu of a broad based fund while the S&P 500 is below its 200 DMA makes sense. I sort of touched on this recently talking about the PowerShares Buy Write ETF (PBP) which I own personally and for a couple of clients.

The bigger macro IMO is that when demand for equities is poor what steps do you think you should take, if any, to look less like the market? Owning the right covered call fund certainly could be part of the solution. Where domestic exposure in this space is concerned I think the ETF might be the better wrapper.

Look at the chart. It compares the market price of the S&P 500 Covered Call Fund (BEP) to the net asset value of that fund and the S&P 500 index.

The NAV appears to have about equaled the index but there have been two dividends of $1 each in the year charted so the NAV has outperformed the index noticeably.

The market price appears to have lagged the index by a meaningful amount, add in the dividend it is a slight beat for BEP. PBP has had a more meaningful albeit less volatile run of outperformance.

And the thing that is difficult is that the next go around BEP could do much better or much worse it just depends. The issue, as I see it, is that changes in fear and greed are what move the CEFs and that issue doesn't really exist with the ETF market.

The effect that I have written about trying to achieve in this context is to look less like the market with the portfolio when demand for equities is unhealthy. Obviously some things will be more volatile than the market, some less but what matters is the overall blend.

Pursuing this becomes easier if you can reasonably predict how various holdings will do. What I mean by that is if you have an industrial stock you can have a good sense whether that stock is typically more or less volatile than the sector in general. In a simplified world if you have one stock for each of the ten S&P sectors and each of those stocks is less volatile than their respective sectors it is a good bet that the overall portfolio will be less volatile than the broad market.

Not everything can be predictable all the time of course but taking on CEFs can reduce the predictability of the portfolio. Some of that will go with the territory but if you take on a CEF and you want a little more predictability in a bear market you may need to offset the CEF with something else.