Option-Income CEFs May Be a Smarter Choice

Last month I whistled a flagrant foul on closed-end funds that use legerdemain to pay fat distributions (not dividends per se) but do so at the cost of the erosion of the funds' asset values. This month I offer a better alternative: closed-end funds that distribute cash at an annual rate of 8% to 16% by selling covered call options and passing along the proceeds to shareholders.

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There are roughly 30 option-income CEFs (get the list). They run the gamut from funds that focus on the 30 stocks in the Dow Jones industrials to those that sell options on emerging-markets stocks.

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Key advantages. Whatever their strategy, option-income CEFs share two virtues. First, all trade at discounts to their net asset value per share. Second, these funds are ideal for a market stuck in a fairly narrow trading range -- that is, the sort we've experienced for much of the past year.

To see why, you need to understand how a covered-call strategy works. A call option gives its holder the right to buy, or call, a stock from the option's seller at a certain price by a certain date. Buying options is risky. But selling a call against a stock you own is a conservative strategy. By doing so, you limit the potential appreciation of your stocks, but you generate additional income through the sale of the options. And if you sell calls against such sturdy blue chips as AT&T and McDonald's, you collect not only option income but also a steady stream of dividends. (This is not to say these are buy-and-forget funds; if the stock market crashes, option-income funds will suffer, too.)

Option-income funds designate much of their distributions as a "return of capital," a phrase that suggests you're not getting a true dividend. But just as there is good cholesterol and bad cholesterol, there are good and bad returns of capital. Cash inflows from option sales are repeatable and sustainable. So, unless an options-based fund is mismanaged, it shouldn't suffer the long-term erosion of NAV that plagues CEFs that regularly liquidate assets to maintain high payouts.

A good way to tell whether an options-selling CEF is okay to own is to study the data in shareholder reports. Specifically, says options expert Greg Pugh, compare the "net increase in net assets from operations" with total cash distributions. If the increase in net assets exceeds the payout or lags it only slightly, "that will give you a good feel for the sustainability of the distribution," he says.

For example, in 2010, Eaton Vance Enhanced Equity Income II (symbol EOS) distributed $6 million more than its assets grew, counting income from selling options. If such losses were to continue uninterrupted, the fund's net asset value would eventually come under pressure. But in the first half of 2011, the fund's increase in assets exceeded its payouts by $3.3 million, so over an 18-month period, the fund barely had to dip into its resources to cover the $95 million it made in payouts. In a fund as large as this one is (assets total $578 million), such a small loss is acceptable. Based on the past year's distributions, the fund yields 9.3% on NAV. And because the shares, at $10, trade at a 13% discount to NAV, the yield on the share price is a fat 10.6% (prices are as of January 6).

Below are three other CEFs I like, along with share prices, discounts to NAV and current yields based on share prices: Dow 30 Premium & Dividend Income (DPD; $13; 7% discount; 8.0% yield), which is managed by Nuveen, sells calls against the stocks in the Dow Jones industrials. Nuveen Equity Premium & Growth (JPG; $12; 13% discount; 9.1% yield) builds a portfolio designed to track Standard & Poor's 500-stock index, then sells index call options on about 80% of the fund's holdings. Cohen & Steers Global Income Builder (INB; $10; 12% discount; 11.7% yield) divides its assets nearly evenly between U.S. and foreign stocks. Unlike the other CEFs, Cohen & Steers uses borrowed money to lift returns. That increases risk.