Covered-Call Funds Offer Big Payouts

The market's manic moves might have you feeling like the main thing stocks are good for is raising your blood pressure, not raising your net worth. But there's one type of investment that may both calm your nerves and boost your income: covered-call funds.

These funds earn extra income by selling call options on the stocks in their portfolios. Call options give the buyer the right to purchase a stock at a set price within a certain time period. Here’s how it works: Imagine a fund owns shares of ABC, which currently trades for $50. The fund might sell a call option that gives the buyer the right to buy ABC shares for $60, within one month. And suppose the fund earns $2 per share in income for selling the option. If ABC shares rise to $65 during that month, the buyer will exercise his or her option and the fund will hand over its ABC shares, having earned $12 per share instead of $15. If the stock instead falls to $40, the option will expire unexercised and the fund will have lost just $8 per share, rather than $10. And if the stock price ho-hums along to $51, the fund nets $3 per share in profits.

As that math illustrates, covered-call strategies tend to lead in sideways and down markets, but lag in strong bull markets. Because the price of options rises when market volatility increases, market chop also tends to boost the funds’ returns. So if the market continues on its jagged sideways course, covered-call funds could shine.

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Look for Closed-End Funds

The best covered-call funds are the closed-end variety. Unlike traditional mutual funds, closed-ends issue a fixed number of shares and then trade on exchanges. That arrangement often drives the funds’ share prices to diverge from the actual value of their underlying holdings (or "net asset value"). Happily for investors, many of these funds are trading at generous discounts.

Two fine options are Eaton Vance Enhanced Equity Income (symbol EOI) and Eaton Vance Enhanced Equity Income II (EOS). The main difference, says co-manager Michael Allison, is that the former measures itself against Standard & Poor’s 500-stock index and the latter uses the Russell 1000 Growth index as its benchmark (meaning it will hold more shares of midsize and fast-growing companies than the first fund). Managers of each fund buy shares of stocks that they believe have solid appreciation potential. They then sell call options on almost every stock in the portfolio, making occasional exceptions for stocks they believe could see a big near-term pop in price. Managers only sell options on half of their position in each stock, so that they never lose an entire position in a winning stock.

Both funds pay hefty income. The Enhanced Equity Income fund's $0.0864 monthly distribution as of May represents an 8.1% yield on the fund's market price as of May 23. The fund trades at a 3.1% discount to the value of its underlying assets. Enhanced Equity Income II currently pays 8.2% and trades at a 6.2% discount.

Another solid choice is BlackRock Enhanced Equity Dividend Trust (BDJ), which focuses on dividend-paying stocks. The fund's managers typically separate the stocks in the portfolio into three buckets, depending on whether they believe a stock has high, medium or low potential for price appreciation, says co-manager Kyle McClements. They'll then sell the most options on the stocks with the least appreciation potential, and may not sell any options at all on those they believe could see a big surge. The fund currently trades at a hefty 11.7% discount and pays a 7.4% distribution.

One cautionary note about the funds' distributions: Just as covered-call funds lag during strong bull markets, they can also have trouble recovering from bear markets, because the stocks in their portfolios get called away while they still have room to run. Many covered-call funds' net asset values still haven't recovered from the 2007-09 bear market. For investors who reinvest distributions, this has not necessarily hampered total returns, because those investors accumulate more shares over time. But if your goal is to use the funds' payouts for living expenses, understand that the funds' net asset values may erode over the long run, leading to cuts in their distributions.