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Mutual Funds

You're Gonna Love Those Yields

By selling covered call options, these closed-end funds generate tons of cash.

On those discomfiting days when the market forgets which way is up, there's nothing like a little cold, hard cash. To collect more of the green stuff, consider investing in a fund that sells covered call options. These funds employ a relatively conservative strategy to churn out exceptional yields that can rise along with market volatility.

Particularly compelling are closed-end funds that sell options. Closed-ends issue a set number of shares at an initial offering, then trade on exchanges just like stocks do. Investor sentiment often drives their share prices to a point at which the funds trade for less -- sometimes significantly less -- than the value of their underlying holdings.

Because of broad, indiscriminate selling that began last July, many closed-end covered-call funds now trade at 10% to 15% discounts to net asset value (NAV), making them good buys. As recently as last spring, many traded at modest premiums to NAV.

How it works. A covered-call strategy boosts income while potentially limiting gains. The seller, or writer, of a covered call sells the right to buy a stock that he or she owns at a set price within a set time period.

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For that privilege, the buyer of the option pays the seller a premium. The seller pockets the premium but limits appreciation potential because if the stock's price rises beyond the so-called strike price, the buyer will exercise the option and call the shares away. And if the stock craters, you can end up with big losses that are only slightly mitigated by the call premium. "The pitfall is you cap your upside but you're still exposed on the downside," says Tom Roseen, an analyst with fund tracker Lipper.

The good news for call sellers is that options prices tend to rise with market volatility. "We're in almost a perfect environment right now because the market hasn't gone anywhere but volatility has been strong," says Christoph Hoffman, head of closed-end funds for Allianz.

It's important to check under the hood before you invest in a covered-call closed-end. If a fund's yield is too high (on average, funds in this category yielded 9.0% over the past 12 months), it may be a sign that the fund is paying out more in dividends than it's earning. Such a strategy will lead to the erosion of a fund's NAV over time and, probably, a lower share price.

One solid closed-end is NFJ Dividend, Interest & Premium Strategy (symbol NFJ). It invests in stocks of large, undervalued companies and sells call options on Standard & PoorUs 500-stock index. The fund generates additional income by investing 75% of assets in high-dividend-paying stocks and the rest in convertible bonds. The fund returned 19% on its assets in 2006, its first full year, and 10% in the first 11 months of 2007. At its mid-December price of $24, NFJ yielded 8.7% and sold at a 7.2% discount to NAV.

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New entrants are developing more-sophisticated strategies. Mariana Bush, closed-end analyst at Wachovia, favors Eaton Vance Risk-Managed Diversified Equity Income (ETJ), which combines call options and put options to generate income and protect against falling share prices (a put gives its holder the right to sell a stock at a specified price by a certain date). It recently yielded 10.2% and traded at an 11% discount to NAV. The fund, which launched in July, returned 2.7% between October 9, when the market reached its autumn high, and December 10, beating the S&P 500 by seven percentage points.

A global covered-call fund worth considering is BlackRock World Investment Trust (BWC). The fund invests primarily in large-company stocks and sells individual call options on 50% to 60% of the issues in its portfolio. It recently had 70% of assets invested outside the U.S., primarily in Western Europe. World Investment Trust returned 22% on its assets in 2006 and 17% in 2007 to December 10. It traded at a 5.3% discount to NAV and yielded 8.0%.