GETTING PERSONAL: How Buy-Write Lost Its Magic
May 26 2011 - 2:57PM
Dow Jones News
Buy-write funds were supposed to be one of the investment
industry's brightest new ideas. But after initial success during
the financial crisis, many are struggling to keep pace with the
rebound.
Buy-write funds, also called covered-call funds, typically buy a
portfolio of stocks, then sell call options on their holdings. The
options generate income that can cushion against potential losses
and boost funds' annual payouts, both features that are attractive
to many income-oriented investors.
The strategy proved a big hit in the stingy yield environment
during the years leading up to the financial crisis. At the time, a
parade of new closed-end funds scored billion-dollar initial public
offerings and buy-write exchange-traded notes and funds began to
appear. Today, about three dozen buy-write vehicles hold roughly
$27 billion, based on tallies by Morningstar Inc. and Lipper
Inc.
Investors that bought buy-write funds at the height of their
popularity likely saw their investments shielded from the worst of
the bear market. But since then, the funds' record has been
decidedly mixed. While selling call options can lead to easy
profits as stocks fall, the strategy tends to cap investors'
returns during a rally, since the buyers of the options share in
the funds' gains. Funds' fat yields have come under stress, too, in
part because funds stretched to maintain big payouts amid the
crisis and in part because of shifting patterns in stock-market
volatility.
The funds "did what they were supposed to do in 2008," says
Morningstar Analyst Cara Esser. Since then, "the strategy hasn't
been spectacular."
Measuring performance for buy-write funds as a group is tricky
because the strategy can be interpreted many different ways, making
funds hard to categorize. But returns of the PowerShares S&P
500 BuyWrite ETF (PBP), which tracks a common buy-write benchmark,
offer at least one take. It did comparatively well during the
financial crisis, posting a negative return of 29% in 2008, its
first full year on the market. While substantial, the loss was
considerably narrower than the Standard & Poor's 500's 37%
decline.
Since then, however, the PowerShares ETF has steadily lagged. As
a result, it has posted average annual declines of about 1.3% over
the last three years, while the S&P 500 has gained 0.9% a
year.
PowerShares says hypothetical tests of the fund's benchmark show
returns that are "similar" to the S&P 500 over longer periods
and with less volatility.
Perhaps an even bigger issue, especially for investors who own
closed-end funds--the most common buy-write vehicle--is what may
happen to these funds' hefty yields.
By selling call options on their stock holdings, buy-write funds
generate steady income that, along with the stocks' dividends, can
be handed back to investors. But because big yields are so popular,
many funds also turn to another source to boost payouts further:
proceeds from trading stocks in their portfolios. Relying on these
trading profits works in a rising market, but the tactic is risky
if stocks are flat or fall because it eats away at the fund's asset
base.
While the stock market has bounced back from its financial
crisis lows, closed-end fund analysts worry that past efforts to
maintain distributions during the bear market and other factors,
like recent declines in stock-market volatility that make selling
options less profitable, have put funds' distributions at risk.
"There was a race for the highest yield," says Wells Fargo
Advisors analyst Mariana Bush. Managers made assumptions that now
seem "a bit optimistic."
One big-name company, Eaton Vance Corp. (EV) cut distributions
on eight of its covered-call funds late last year, including Eaton
Vance Tax-Managed Global Diversified Equity Income (EXG), whose
$5.5 billion 2007 initial public offering remains the largest ever
for a closed-end fund. Today, the fund yields 10%, according to
Morningstar.
Others have resisted that move. BlackRock Inc. (BLK) has avoided
cutting distributions on funds like BlackRock International Growth
& Income (BGY), yielding 13%, and BlackRock Enhanced Equity
Dividend (BDJ), yielding 11%, despite criticism from both
Morningstar and Wells Fargo.
Eaton Vance said its distribution cuts helped make funds' new
distribution levels "reasonable." BlackRock declined to
comment.
-By Ian Salisbury, Dow Jones Newswires; 212-416-2241;
ian.salisbury@dowjones.com