Looking for cover

Covered call strategies in a closed-end fund may help long-term investors manage short-term volatility.

Successful investing is not just about reaching the final destination; the journey itself can be equally important. Equity investors in particular need to account for the likelihood of volatility along the way and seek strategies for limiting loss while staying in the market.

The impact of steep losses on long-term returns can be significant, as the chart below shows. Investors may want to consider lower volatility strategies, such as those used by equity covered call closed-end funds (“CEFs”), which can help to manage portfolio risk and potentially produce a better risk-adjusted outcome.

What are covered calls?

Insurance markets allow purchasers to protect against uncertain events and risks. For instance, automobile insurance protects car owners in the unfortunate event of an accident in exchange for a premium. Option markets work in a similar fashion. (An option is a contract that gives an investor the right, but not the obligation, to buy a security at a later date at an agreed-upon price.)

Investors who want to protect their portfolios from volatility or other uncertain outcomes can sell, or “write,” options on their current stock holdings. The seller receives an upfront “option premium” these premiums generate cash flows, which can help to offset some of the downside risk of owning the underlying stock. In exchange, the option writer (or seller) is obligated to sell the underlying equity security at the call’s strike price if the buyer chooses to exercise the option. As a result, upside participation potential is limited by the strike price plus the initial premium. By using an equity covered call strategy, investors may reduce portfolio volatility by capturing option premiums, potentially enhancing risk-adjusted returns.

Read more about covered calls.

The role of active management

Combining active security selection with an active option overwrite strategy may produce better outcomes for equity-income investors, specifically in the CEF structure. BlackRock equity covered call CEFs employ a strategy that includes a focus on single stock options while varying the amount of overwriting (selling) on the portfolio (typically between 30-60%) as well as diversifying both the moneyness * and time to maturity of the options. As indicated in Exhibit 2, this approach has produced lower downside capture ratios than the underlying index for each fund. In addition, the funds have achieved higher upside capture ratios than their downside capture ratios since their respective inceptions. This asymmetric capture ratio means that, on average, the funds have achieved greater participation in rising markets with comparably lower participation in declining markets. As a result, the funds have generally been able to produce superior risk-adjusted returns as shown by their Sharpe Ratio when compared to the underlying equity benchmark (see Exhibit 3).

* Moneyness: relative position of the current price of a stock with respect to the option’s strike price.

Exhibit 2

Who can potentially benefit from equity covered call strategies?

CEFs that employ an equity covered call strategy may benefit equity income investors seeking the following qualities.

• Potential for higher risk-adjusted returns as compared to a long-only equity portfolio. Over a market cycle, equity covered call strategies have generally exhibited the ability to reduce portfolio volatility without sacrificing performance as compared to a long-only benchmark as seen in the Sharpe Ratio exhibit 3.

Exhibit 3

In the face of increasingly volatile markets, investors should consider providing cover for their portfolio by using covered call strategies.

Learn more about CEFs.

**equity covered call CEFs are represented by the Lipper Option Strategies/Option Arbitrage Funds category and equity income mutual funds are represented by the Lipper Equity Income Funds category.