income generation Funds Use Options For Income Generation

"Funds using options to generate extra income or cushion against losses, or both, are gaining attention."

Wall Street Journal, Apr 3, 2011

Income generation is an important aspect of running a mutual fund. Dividends are good, but dividends plus call premium is often better. For fund managers trying to reduce volatility and increase income, covered calls are a logical choice.

The CBOE's S&P 500 Buy-Write index, which tracks covered calls, outperformed the S&P 500's index over the last 10 years with annualized returns of 3.5% vs 3.4%. But the S&P 500 had 30% more volatility than the CBOE index.

Let's take a look at how some funds use covered calls:

Gateway is one of the longest running funds using covered calls. They mostly write covered calls on indexes, rather than on specific stocks. They have beaten the S&P 500 over the last decade and, according to the fund manager, they've done it with 55% less risk.

Neiman Large Cap Value owns mostly dividend-paying stocks that it sells covered calls on to generate income. The average dividend is 2%, and their goal is to double that with call premium while leaving themselves some upside potential.

Aston/M.D. Sass Enhanced Equity owns large-cap value companies and sells covered calls with expiration dates 6 months out (longer than the average of 1 or 2 months). The fund's manager says that allows him to pocket a larger share of the stock's upside potential, and helps meet the fund's goal of cash flow from calls and dividends of 10% or more per year.

Using covered calls for income generation is a common strategy employed by fund managers to increase returns. It is not optimal for all situations, though. If you own high-growth stocks during a raging bull market then you are probably better off with a buy-and-hold strategy. Because while the call premium income will reduce your volatility, it will also cap your upside.

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.

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