Thanks to a variety of factors, portfolios are having to cope with a lot these days. From geopolitical risks and volatility to inflation and economic slowdowns, a simple mix of stocks and bonds isn’t cutting it. Asset classes and strategies need to do a lot of heavy lifting to combat all of these factors and new risks. One of the biggest trends in combating these issues happens to be derivatives and the use of options.
While they may seem fancy, shiny, and new, options have been a hallmark of many closed-end funds (CEFs).
With that, CEFs can provide some benefits when it comes to implementing options into a portfolio. From tax savings, lower volatility, and high yields/returns, the fund structure provides a great way for investors to use derivatives in their portfolios and get through the current malaise.
Options as an Income & Diversification Tool
For many investors, derivatives like options are something they simply ignore, with the connotation they are strictly for advanced traders, hedge funds, and investment banks. But the truth is, at their core, options are basically insurance policies designed to reduce risk and create ‘known’ outcomes. By definition, options of any kind include the right but not the obligation to buy or sell something at a certain price. That could be single stocks, ETFs, indexes, commodities or fixed income assets.
Today, options strategies are being used to generate income and reduce volatility.
The most popular way has been the growth of derivative-income ETFs. Funds such as JPMorgan Equity Premium Income ETF and iShares 20+ Year Treasury Bond BuyWrite Strategy ETF have gathered billions in assets by using covered-call or buy-write strategies to generate income from a portfolio of assets.
In exchange for writing call options, investors are paid a premium. Unlike bonds, options generate extra income that is not tied to interest rates, and provide lower volatility and downside protection to a portfolio. The proof of this added diversification and stability has been better returns. Both full- and partial-covered-call equity approaches have outperformed the broader bond aggregate index over the last 30 years.
This chart from J.P. Morgan shows broad asset classes, a 60/40 portfolio, and three different options indexes. As you can see, the more income-focused collared equity strategy (CLLZ) and call writing strategy (BXM) indexes outperformed the U.S. Agg bond index, while the partial call writing strategy index (BXMH) outperformed the diversified 60/40 portfolio.
Source: J.P. Morgan
Closed-End Funds for Options
While the growth of option-focused ETFs has been swift, investors may not want to go straight for the shiny new object. CEFs have been dabbling in the world of options income for decades. And there are certain wins and benefits for using the structure over an ETF.
Like their ETF cousins, covered call and options income CEFs provide the same potential benefits of lower volatility and increasing income by combining a traditional equity portfolio with a call option selling program.
The benefit is investors could get a higher yield on an options CEF versus an ETF. That’s because closed-end funds are allowed to employ leverage in their portfolios. More than 70% of closed-end funds employ some kind of leverage via preferred share issuance or short-term debt. That leverage is regulated to a percentage of assets to prevent the fund from going too far. That leverage is enough to provide extra juice to yield. For example, open-end funds like mutual funds and ETFs using options are currently paying around 3.9%. This compares to over 9% for the average CEF.
Additionally, the fact that CEFs can trade at a discount to their net asset values (NAVs) can also provide additional yield.
Aside from a higher yield, options-focused closed-end funds have the potential to provide a smoother ride than ETFs. That’s because many CEFs follow a managed distribution plan with their dividends/distributions. A managed distribution program allows a CEF to pay actual and expected capital gains throughout the year, not just as a single year-end distribution.
One of the main benefits of using options in the first place is to manage volatility and create a steady base of returns. By using a CEF, an investor ‘knows’ they’ll get X% per year and that can go a long way toward meeting the goal of volatility smoothing within a portfolio. For options ETFs, options premiums and distributions tend to be all over the place based on current market conditions. By using a managed distribution approach, there’s increased diversification and income potential from investments in equities and other strategies with historically high appreciation potential.
Adding a Dose of Option Income With CEFs
Given the added benefits of using a closed-end fund for options income—such as higher yields and smoother income—it makes sense to use the fund structure in a portfolio. Now, an options income fund—whether CEF or ETF—shouldn’t be your entire equity holding, however. The way options work is they do cap potential upside in exchange for the premium/income. The idea is to use them in concert with a broader equity/bond portfolio to smooth out the ride, reduce volatility, and boost yield.
Adding one or two options CEFs to a portfolio makes sense And luckily, the number of such funds continues to grow.
Options Income CEFs
These CEFs were selected based on their exposure and mandates to buy-write, options income, and derivatives-focused strategies. They are sorted by their YTD total return, which ranges from -2.34% to 6.68%. They have expenses between 0.85% and 1.12% and assets between $154M and $1.6B. They are currently yielding between 6.9% and 10.2%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| XBDJX | BlackRock Enhanced Equity Dividend Trust | $1.5B | 6.68% | 8.55% | 0.85% | MF | Yes |
| XBOEX | BlackRock Enhanced Global Dividend Trust | $627M | 6.59% | 8.8% | 1.07% | MF | Yes |
| XIGAX | Voya Global Advantage & Premium Opportunity Fund | $154M | 6.07% | 10.16% | 1.1% | MF | Yes |
| XFFAX | First Trust Enhanced Equity Income Fund | $401M | 1.93% | 6.9% | 1.12% | MF | Yes |
| XETVX | Eaton Vance Tax-Managed Buy-Write Opportunities Fund | $1.6B | -1.1% | 8.77% | 1.08% | MF | Yes |
| XDIAX | Nuveen Dow 30 Dynamic Overwrite Fund | $517M | -2.34% | 8.47% | 0.92% | MF | Yes |
Overall, options income has grown in popularity among investors looking to smooth out their rides and increase their portfolios’ yields. Closed-end funds offer some interesting benefits for the strategy. With higher yields and managed distributions, CEFs make for an ideal way to add options income into a portfolio.
The Bottom Line
Options income is one area where closed-end funds truly shine. Adding some extra benefits to the strategy, investors may want to consider using CEFs when looking to add options to their portfolios.
