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Assessing High-Income Covered Call CEFs

Summary Covered call CEFs provided an average income of about 8.5% with risks only slightly greater than the S&P 500. In general, during the recent strong bull market, most covered call CEFs lagged the S&P 500 on a risk-adjusted basis. Since 2007, covered call CEFs have consistently outperformed the covered call ETF (PBP) on a risk-adjusted basis. As an income-focused investor, I’m a fan of covered call Closed End Funds (CEFs) and have written several articles on Seeking Alpha discussing their risks and rewards. For this article, I reviewed my previous analyses and selected ten of best-performing CEFs that delivered good returns at a reasonable risk (as measured by volatility). However, before I launch into the results of the analysis, I will provide a quick tutorial for the investors that may not be familiar with covered calls. The basic idea of investing in covered calls is simple. An investor will buy a stock and write (that is sell) a call option against their stock position. Since the investor owns the stock, the position is termed “covered.” The call option will give the buyer the right (but not the obligation) to purchase the stock at an agreed upon price (called the strike price) any time before the expiration date of the option. For this right, the call buyer pays a premium to the writer (the investor who sells the option). If the price of the stock increases above the strike price before the expiration date, then the option buyer may “call away” the stock from the writer, that is, the writer is forced to sell the stock at the strike price. If the price of the stock does not increase above the strike price, then the option expires worthless and the writer can pocket the premium. Thus, covered calls are a way to receive additional income but in return, the writer sacrifices some of the upside potential of the stocks. In a strong bull market, you would expect the covered call strategy to under-perform the S&P 500 because many of the best performing stocks will be “called away.” But during a correction, the premiums provide a buffer to limit losses so, theoretically, writing covered calls should decrease volatility. This is not always true since volatility is dependent on the specific strategy implemented by the writer. Although simple in principle, actually implementing a profitable covered call strategy is not that easy. The investor must not only select a suitable stock but must also select the option to write and when to close or rollover positions. My favorite way to add covered calls to my portfolio is via CEFs because they are actively managed and provide excellent distributions. However, as with most CEFs, you may experience higher volatility due to the active management coupled with the fact that CEFs may sell at a premium or discount to Net Asset Value (NAV). The covered call CEF investors should also understand some of the unique aspects associated with Return of Capital (ROC). Return of capital has a bad connotation because it is usually associated with a fund literally returning part of the capital you invested. This would be bad and result in a decrease in NAV. However, the exact definition of ROC depends on complex accounting and tax rules. For example, if a fund receives a premium from writing a call, this premium cannot be booked as income until the option either expires or is closed out. In addition, in a bull market, the fund manager may decide to not sell stocks that have greatly appreciated but instead use income that he has accumulated on his balance sheet to pay the distribution. In both these cases, part of the distribution may be labeled as ROC but it is not destructive. My rule of thumb is that ROC is not destructive as long as the NAV continues to increase. Another important metric for CEF investors is the Undistributed Net Investment Income (UNII). As the name implies, this is the amount of income that has not yet been distributed. A positive UNII means that he funds has some reserves that can be used for distributions in the future. On the other hand, a negative UNII indicates that the fund has dipped into reserves to make up for a short fall in income. A small positive or negative UNII is usually not very significant. However, if the UNII is negative and is large relative to the distributions, this could be a red flag that the distributions may not be sustainable in the future. The ten CEFs that I selected are summarized below. I apologize in advance if I did not include your favorite covered call funds. However, I welcome comments from readers on funds that have performed well. It should also be noted that some of my favorite covered call CEFs, like Nuveen’s Enhanced Premium and Income (DPO) were recently merged with other funds so were not included in the analysis. BlackRock Enhanced Equity Dividend (NYSE: BDJ ). This CEF sells for a 10.5% discount, which is slightly smaller than its 3-year average discount of 11.2%. The portfolio consists of 94 holdings, invested primarily in large cap equities from the United States. The stock selection criteria is focused on equities that pay dividends. Options are written on about 50% of the portfolio. In 2008, the price of the fund dropped about 17%. This fund does not utilize leverage and has an expense ratio of 0.9%. The fund has a distribution rate of 6.9%, paid primarily from income and ROC. The ROC appears to be non-destructive since the NAV has increased over the past year and the UNII is small. BlackRock Enhanced Capital and Income (NYSE: CII ) . This is the oldest covered call CEF with an inception date of 2004. It currently sells at a discount of 7.6%, which is a smaller discount than the 3-year average discount of 8.5%. This fund is relatively concentrated, with only 75 holdings that are primarily (83%) U.S companies. The fund managers have a flexible mandate and can invest in all size companies but most are medium to large cap. The price of this fund dropped 36% in 2008. The fund typically writes options on about 50% of the portfolio. The fund does not use leverage and has an expense ratio of 0.9%. The distribution is 8.2% with a significant portion of the distribution coming from ROC but the ROC appears to be non-destructive since the NAV has increased over the past year and the UNII is small. Eaton Vance Enhanced Equity Income (NYSE: EOI ). This fund sells at a 7.2% discount, which is smaller than the 3-year average discount of 10.2%. This fund contains 42 large cap holdings, all from the United States and writes options on about 50% of the portfolio. The price of this fund lost about 26% in 2008. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is currently 7.5% funded primarily from short term gains and ROC. The ROC appears to be non-destructive since the NAV has increased over the past year. However, the UNII is negative and relatively large with respect to the distribution size, creating some concern on the sustainability of the distribution. Eaton Vance Enhanced Equity Income II (NYSE: EOS ). This sister fund to EOI sells at a discount of 5.6%, which is smaller than its 3-year average discount of 9%. The fund has 88 large and mid-cap holdings, all from the United States. The fund writes options on 50% of the portfolio, does not use leverage, and has an expense ratio of 1.1%. The fund lost about 32% in 2008. The distribution is currently 7.6% funded primarily from long and short term gains with some ROC. The ROC appears to be non-destructive since the NAV has increased over the past year. However, as with EOI, the UNII is negative and relatively large with respect to the distribution size, creating some concern on the sustainability of the distribution. This fund is highly correlated (90%) with EOI. Eaton Vance Tax-Managed Buy-Write Income (NYSE: ETB ). This CEF sells for a discount of 2.3%, which is smaller than the 3-year average discount of 5.7%. The portfolio consists of 183 holdings, with 100% domiciled in the United States. The fund writes calls on almost all of the assets. The price of this fund only dropped 19% in 2008. The name “tax-managed” means that the fund managers try to minimize the tax burden by periodically selling stocks that have incurred losses and replacing them with similar holdings. This strategy has the effect of reducing or delaying taxable gains. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 8.2%, funded primarily from ROC. The ROC appears to be non-destructive over the past year but the UNII is large compared to the distribution, which is a concern. Eaton Vance Tax-Managed Buy-Write Opportunities (NYSE: ETV ). This CEF sells at a discount of 3.2%, which is smaller than the 3-year average discount of 6.3%. This is a large fund with 208 holdings, all from the United States. About 60% of the holdings are from S&P 500 stocks and the other 40% are from NASDAQ stocks. The fund writes options on about 85% of the portfolio. The price of this fund dropped 30% in 2008. The fund does not use leverage and has an expense ratio of 1.1%. The current distribution is 9.1% funded primarily by non-destructive ROC. The ROC appears to be non-destructive over the past year but the UNII is large compared to the distribution, which is a red flag. Eaton Vance Tax-Managed Global Buy-Write Opportunities (NYSE: ETW ) . This CEF sells at a discount of 4.8%, which is less than the 3-year average discount of 9.2%. This is a large fund with 457 holdings, with 55% from U.S. firms. After the United States, the largest holdings are from Europe. The fund utilizes index options that cover most of the value of the portfolio. The price of this fund dropped 33% in 2008. The fund does not use leverage and the expense ratio is 1.1%. The distribution is 9.9% paid primarily from ROC. Over the past year, some of the ROC may have been destructive as evidenced by the decrease in NAV and relatively large UNII. Eaton Vance Tax-Managed Dividend Equity Income (NYSE: ETY ). This CEF sells for an 8.3%% discount, which is slightly smaller than the 3-year average discount of 10.3%. The fund has 65 holdings, all from the United States. The fund typically writes options on the S&P 500 index rather than individual stocks. The price of this fund dropped 25% in 2008. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 8.9%, paid primarily from income and ROC. The ROC appears to be non-destructive over the past year but the UNII is relatively large compared to the distribution, which is a concern. Voya Global Advantage and Premium Opportunity (NYSE: IGA ). This CEF sells at a discount of 8.4%, which larger than the 3-year average discount of 6.9%. The fund has 110 holdings, with 60% from the U.S. and the rest from Europe and Asia. The fund hedges currency risks and sells options on 50% to 100% of the portfolio value. The price of this fund dropped 35% in 2008. It does not use leverage and has an expense ratio of 1%. This distribution is 9.7%, funded primarily from ROC. Some of the ROC may have been destructive over the last year since the NAV decreased. However, the UNII is positive, which is a good sign. Cohen & Steers Global Income Builder (NYSE: INB ). This CEF sells at a small discount of 0.5%, which is smaller than the 3-year average discount of 5%. The portfolio has 227 holdings, with 90% in equity and 11% in other income focused securities such as preferred stock. About 55% of the holdings are domiciled in the United States with the rest diversified globally among many different countries. This is one of the few covered call CEFs that use leverage (currently about 19% leverage). The expense ratio is 1.8% and the distribution is 9.5%, paid primarily with ROC. Over the past year some of the ROC may have been destructive as evidenced by the decrease in NAV and the relatively large negative UNII. For reference I also included the following funds in the analysis: SPDR S&P 500 (NYSEARCA: SPY ). This ETF tracks the S&P 500 index and has an ultra-low expense ratio of 0.09%. It yields 1.8%. SPY will be used to compare covered call funds to the broad stock market. PowerShares S&P 500 BuyWrite (NYSEARCA: PBP ). This is the only ETF that is liquid and has a history that goes back to 2007. It tracks the CBOE S&P 500 BuyWrite Index, which measures the return received by buying the 500 stocks in the S&P Index and selling a succession of one-month, near-the-money S&P 500 index call options. The fund has an expense ratio of .75% and yields 5.1%. This ETF was launched in December of 2007 so its data does not quite span the entire bear-bull cycle. Assuming equal weight, a portfolio of these CEFs averages 8.5%, which satisfies my desire for high income. But total return and risk are as important to me as income so I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility for each of the component funds. I used a look-back period from October 12, 2007 (the market high before the bear market collapse) to 5 February, 2015. The Smartfolio 3 program was used to generate the plot shown in Figure 1. Note that this plot is based on price and not on the NAV of the funds. NAV is a valuable metric for some analyzes but for risk and return I prefer price since it is the metric that determines actual profits and losses. (click to enlarge) Figure 1. Risk versus reward over bear-bull cycle Figure 1 illustrates that the covered call CEFs have had a large range of returns and volatilities over the bear-bull cycle. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY. Similarly, the blue line represents the Sharpe Ratio of PBP. Some interesting observations are evident from the figure. The passively managed PBP had a volatility much less than the S&P 500. However, the PBP return was also small resulting in a risk-adjusted performance that was worse than any of the CEFs. Covered call CEFs are a volatile asset class, with volatilities slightly greater than the S&P 500. This might surprise some since covered calls are touted to reduce volatility. However, this is the nature of CEFs. As amply illustrated by the plot, the actively managed covered call CEFs are substantially more volatile than the passive covered call ETF. On a risk-adjusted basis, only a few covered call CEFs (ETV, ETB, and CII) was able to outperform the S&P500 on a risk-adjusted basis. Most of the CEFs had risk-adjusted performance that was greater than PBP but less than SPY. Of the CEFs, the worst performance was booked by BDJ. The most volatile CEF was INB, likely due to the global exposure of this fund. I next wanted to assess the degree of diversification you might receive from purchasing multiple covered call funds. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the covered call funds. I also included SPY to assess the correlation of the funds with the S&P 500. The data is presented in Figure 2. (click to enlarge) Figure 2. Correlations over the bear-bull cycle The figure illustrates what is called a correlation matrix. The symbols for the covered call CEFs are listed in the first column on the left side of the figure along with SPY and PBP. The symbols are also listed along the first row at the top. The number in the intersection of the row and column is the correlation between the two assets. For example, if you follow EOS to the right for two columns you will see that the intersection with CII is 0.770. This indicates that, over the bear-bull period, EOS and CII were 77% correlated. Note that all assets are 100% correlated with themselves so the diagonal of the matrix are all ones. The last two row of the matrix allows us to assess the correlations of the CEFs with PMB and SPY. There are several observations from the correlation matrix. Many of the covered call CEFs are relatively highly correlated (greater than 80%) with SPY. Thus if you have an equity portfolio that mimics the S&P 500, then you may want to purchase the covered call CEFs that are the least correlated with SPY If your portfolio is more esoteric and does not reflect the S&P 500, you are free to select any the covered call funds. Generally, it is OK to purchase more than one of the CEFs if they are not highly correlated with each other. However, it pays to check the pair-wise correlation before you make a final decision. For example, you would not want to purchase both EOS and EOI since these two CEFs are almost 90% correlated. Somewhat surprising, the covered calls CEFs are only moderately correlated with PBP. In fact, the CEFs are more correlated with SPY than they are with PBP. My next step was to assess this portfolio over a shorter timeframe when the S&P 500 was in a strong bull market. I chose a look-back period of 3 years, from February 2012 to the present. The data is shown in Figure 3. The S&P 500 was in a rip roaring bull market over this timeframe and the covered call CEFs had a tough time keeping pace. However, both EOI and EOS were able to book the same risk-adjusted performance as SPY. The leaders over the bear-bull cycle (ETV, ETV, and CII) also performed well but fell short of the SPY performance. All the CEFs were able to outperform PBP on risk-adjusted basis. (click to enlarge) Figure 3. Risks versus rewards over past 3 years As a final test, I used the last 12 months as a look-back period and the results are shown in Figure 4. Over this period, the risks versus reward were similar to the 3 year period except that none of the CEFs were able to match SPY. The data is tightly bunched between the PBP and SPY lines. The best performers were EOS, EOI, and CII. The Voya fund, IGA, lagged during this period. (click to enlarge) Figure 4. Risks versus rewards over past 12 months Bottom Line Over all the time periods of the analysis, covered call CEFs have outperformed their ETF cousin on a risk-adjusted basis but have not been able to consistently beat the S&P 500. This is not surprising given the strong bull market since 2009. Covered call CEFs have offered good distributions but return of capital and the negative UNII associated with many of these funds is a concern. I am a fan of covered call CEFs and believe they have a place in income-oriented retirement portfolios, but they are not for the faint hearted. Also, discounts have been narrowing so my tendency is to wait for better bargains before making new investments. However, no one knows what the future will hold, so investors looking for enhanced income should give these funds serious consideration. Disclosure: The author is long ETW, INB. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

A More Tempered Global Equity Fund

By Patricia Oey Low-volatility strategies, such as the iShares minimum volatility family of exchange-traded funds, can be attractive options for long-term investors. This is because these ETFs’ underlying MSCI indexes generally exhibit less-dramatic declines in bear markets . Over the long term, these muted drawdowns explain much of the strategy’s outperformance versus its cap-weighted benchmark. iShares MSCI All Country World Minimum Volatility (NYSEARCA: ACWV ) tracks an index that is designed to be less volatile than its market-cap-weighted parent index–the MSCI All Country World Index (MSCI ACWI). Low-volatility strategies seek to exploit the observed phenomenon that portfolios with smaller price fluctuations tend to outperform portfolios with larger price fluctuations over the long term. This strategy has had a good track record–as measured by the back-tested performance of this fund’s benchmark index (the index’s live performance commenced in November 2009). Over the trailing 15 and 10 years through Dec. 31, 2014, this fund’s underlying index beat the cap-weighted MSCI ACWI by 393 and 202 basis points annualized, respectively. The risk-adjusted returns were also relatively strong, with 15-year Sortino ratios of 0.73 for the minimum-volatility index and 0.22 for the cap-weighted index. However, low-volatility strategies can underperform for long periods of time and tend to lag in bull markets. This fund is suitable for use as a core holding for long-term investors. Typically, global-equity funds are more volatile than U.S. equity funds, as the former have exposure to both international equities and the associated foreign currency fluctuations. But because global equities are a heterogeneous asset class, there is greater diversity (as evidenced by lower correlations) among its constituents, which allows for greater reduction in overall volatility in a fund that employs a minimum-variance strategy such as ACWV. In fact, the trailing five-year standard deviation of returns for this fund’s index of 9% was significantly lower than the S&P 500’s 13% during that same span. Part of this is due to the benchmark’s lower drawdowns during bear markets. For example, in 2008, when the MSCI ACWI fell 42%, this fund’s benchmark declined 25%. This fund does not hedge its currency exposure, so its returns reflect both asset-price changes and changes in exchange rates between the U.S. dollar and other currencies. In the 10-year period through December 2012, a rising euro, followed by a rising yen (against the U.S. dollar), helped boost the performance of this fund. However, more recently, the rising dollar has hurt the fund’s performance. Fundamental View Historically, low-volatility stocks have outperformed high-volatility stocks over the long term. This “volatility anomaly” was first discovered in 1968 by Bob Haugen, who theorized that behavioral factors were behind this phenomenon. More specifically, investors tend to chase risky stocks, expecting these companies to deliver higher returns. This drives up stock prices of riskier names, which ultimately results in weaker future returns, relative to less-volatile names. Generally, this fund had been heavy in less-volatile sectors including consumer staples, health care, telecoms, and utilities, and light in cyclical sectors including financials, technology, energy, and materials, relative to its parent index (MSCI ACWI). In 2013, the fund’s greater exposure to less-volatile names in the United States and Japan weighed on its performance (relative to the MSCI ACWI), as higher-beta names outperformed in those markets. However, in 2014, the fund’s underweighting in the energy sector boosted this fund’s performance (relative to MSCI ACWI). At this time, dividend-oriented sectors such as consumer staples and utilities have been bid up in the recent low-rate environment, and sectors such as materials and energy are trading at low valuations. This fund’s tilt toward more-expensive sectors and tilt away from cheaper sectors may weigh on future performance. About 50% of this fund’s assets are invested in U.S. equities. As of the first quarter of 2015, the U.S. economy appears to be on stable footing. However, now that the U.S. Federal Reserve’s quantitative-easing program has ended, there is uncertainty on how monetary policy will be managed and how it might ultimately affect asset prices–especially considering that valuations across most major asset classes appear to be somewhat stretched. This fund’s second-largest country allocation is Japan, at 12%. After two “lost decades,” Japan’s equity markets responded very enthusiastically to Prime Minister Shinzo Abe’s programs to jump-start the Japanese economy. At the start of 2013, Japan’s Central Bank unleashed an aggressive monetary easing program. This move provided the foundation for improving macroeconomic fundamentals and corporate earnings growth. Japanese equities may also benefit as Japan’s $1.2 trillion public pension raises allocations in domestic equities and away from low-yielding government bonds. However, any sustainable growth in Japan will require difficult-to-implement structural reforms to address Japan’s inefficient labor market and protected private sector. In addition, Japan’s aging population and massive 200% debt/gross domestic product ratio are two issues that likely will weigh on Japan’s growth in the years to come. European equities comprise 10% of this fund’s portfolio. Many European large caps are high-quality, multinational corporations that have benefited from improving productivity, cheap financing, and exposure to faster-growing emerging markets during the past few years. Most of these firms are in good financial shape. This fund’s largest European country allocations are Switzerland and the United Kingdom, and it has an underweighting (relative to the cap-weighted benchmark) in eurozone countries, such as France and Germany. Portfolio Construction This fund employs full replication to track the MSCI ACWI Minimum Volatility Index, which attempts to create a minimum-variance (or lowest-volatility) portfolio of 350 holdings selected from its parent index, MSCI All Country World Index. It does this using an estimated security covariance matrix (the Barra Global Equity Model) and a number of constraints to limit turnover, ensure investability, and maintain sector and country diversification. This index methodology is somewhat of a black box, as data are not available regarding the estimated risk inputs used for the covariance matrix. The index (and fund) is rebalanced twice a year in May and November. ACWV’s portfolio represents about 20% of its parent index, which includes about 2,400 securities. During the past decade, this minimum-volatility index had a correlation of 0.92 to its parent index. But during the past three years, this correlation was lower, at 0.79. This index was launched in November 2009, so data prior to the initial calculation date reflect hypothetical historical performance. Fees This fund charges an annual expense ratio of 0.20%, which is composed of a management fee of 0.33% and a fee waiver of 0.13%. According to iShares, the fee waiver may be reduced or discontinued at any time without notice. During the past three years, the fund outperformed its benchmark by 16 basis points annualized. This is partly due to the fact that the fund’s benchmark incorporates aggressive foreign tax withholding assumptions. In practice, the fund has had lower foreign tax withholding relative to the estimates incorporated in its benchmark. Dividends are paid out quarterly, and in 2013 and 2012, 86% and 71% of this fund’s dividends were classified as qualified by the Internal Revenue Service, respectively (dividends from companies in certain countries are not considered qualified). Investors should note that some of the dividends paid by stocks in the fund are subject to foreign tax withholding. Investors can claim their portion of the withheld taxes as a tax credit, but only if they hold this fund in a taxable account. Alternatives One similar option is Vanguard Global Minimum Volatility (MUTF: VMNVX ) . Similar to the iShares fund, this Vanguard fund employs quant models to construct a low-volatility portfolio. Key differences are: The Vanguard fund hedges out foreign-currency exposure and has a mid-cap tilt, whereas the iShares fund does not hedge out foreign-currency exposure and has a large-cap tilt. This Vanguard fund is relatively new; its inception was in December 2013. The Admiral share class carries an annual expense ratio of 0.20%. IShares has a suite of low-volatility strategies that cover the different segments of the global equity universe. These ETFs include iShares MSCI USA Minimum Volatility (NYSEARCA: USMV ) , iShares MSCI Emerging Markets Minimum Volatility (NYSEARCA: EEMV ) , iShares MSCI EAFE Minimum Volatility (NYSEARCA: EFAV ) , iShares MSCI Japan Minimum Volatility (NYSEARCA: JPMV ) , iShares MSCI Asia ex Japan Minimum Volatility (NYSEARCA: AXJV ) , and iShares MSCI Europe Minimum Volatility (NYSEARCA: EUMV ) . A solid core allocation option is Vanguard Total World Stock ETF (NYSEARCA: VT ) . This fund tracks the FTSE Global All Cap Index, which seeks to cover 98% of the world’s total investable stock market capitalization and includes approximately 7,500 securities. It has an expense ratio of 0.18%. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.