Defensive equity strategies for yield seeking investors

Diversifying sources of income can be an important strategy for enhancing yield and managing risk. Dividend-paying stocks are one way to diversify a fixed income portfolio, but may expose investors to more equity market risk than they are comfortable with. Income-oriented equity strategies such as covered call closed-end funds may address the need for higher income and equity exposure, and are designed to reduce return volatility and downside risk.

Covered call closed-end funds: Expanding the income universe

Many investors are finding that traditional income sources such as bonds and dividend-paying stocks aren’t meeting their cash flow needs. Closed-end funds may offer comparatively higher income, whether the funds invest in bonds, stocks or other types of securities. This is largely due to their structure and ability to employ leverage. Unlike open-end funds, capital doesn’t flow freely into and out of a closed-end fund after it’s launched; shareholders buy and sell their shares on an exchange, rather than transacting with the fund sponsor. For this reason, closed-end funds have a relatively stable asset base that enables them to pursue a wider array of investments and stay more fully invested than many other investment vehicles. It also enables them to more easily employ leverage, which is used in an effort to enhance both returns and distributions.* Regardless of whether or not they employ leverage, the primary objective of most closed-end funds is to provide shareholders a high level of regular income or distributions.

Covered call closed-end funds provide the same potential benefits of equity closed-end funds but also seek to offer lower volatility and a measure of downside protection. The funds combine a traditional equity portfolio with a call option selling program. The funds typically invest in a portfolio benchmarked to a popular equity index such as the S&P 500 or Nasdaq, and then sell (or “write”) call options on all or a portion of that portfolio, collecting the premiums on the options sold. The option premiums can act as a “buffer” in down markets, helping to offset the decline in the value of the fund’s equity portfolio and therefore, reducing the overall portfolio’s return volatility. In return, the fund sacrifices some of the upside potential of the stocks held because in a rising equity market, if the stock price rises above the option strike price (the price at which the option buyer can exercise the option and purchase the stock), the option would likely be exercised by the option buyer.

The role of active management

Covered call closed-end funds are typically actively managed strategies, with fund managers selecting and managing the underlying equity portfolio as well as the call option strategy or “overlay”—a particularly complex process. The fund may use options on individual stocks, baskets of stocks, a stock index or a combination of some or all of these. It may employ a full overwrite strategy, selling options on the entire value of the underlying stock portfolio which provides less exposure to equity market performance and potentially less volatility, or it may use a dynamic overwrite strategy where options are sold on a varying portion of the underlying stock portfolio providing greater market exposure and higher potential volatility than a full overwrite strategy. Both strategies offer the potential for attractive distributions and diversification of a traditional income portfolio.