How Mutual Funds Come Calling
Mutual-fund companies created "option income" funds in the 1970s. In the 1980s, they all but disappeared. That's not surprising. How could funds that sell off much of the upside potential in their portfolios thrive in a bull market?
Now, the option income fund is making a comeback. Kelmoore Investment Co. of Palo Alto, Calif., recently launched its third fund specializing in writing covered calls--a strategy that generates income by selling the right to purchase fund holdings at specific prices. At least one similar fund, the Dobson Covered Call Fund, started in 1999.
These funds buy stocks for the sole purpose of writing calls. The Kelmoore Strategy Fund aims to earn enough from call premiums on stocks in its blue-chip portfolio, which includes Citigroup (C ) and General Electric (GE ), to pay a monthly dividend of about 1.25% of its assets. Over the past 12 months, it has exceeded this goal with a yield of 22.5%.
Still, the fat yield didn't keep the fund from losing ground. In 2000, Kelmoore Strategy declined by 14.5%, including dividends. The fund paid a price for its heavy concentration in technology stocks, such as Microsoft (MSFT ) and Cisco Systems (CSCO ), because those stocks lost far more than the fund was able to earn by writing calls. Therein lies a lesson about calls: "No matter how attractive the premium, you still have to be right about the stock," says Michael Schwartz, options strategist at CIBC Oppenheimer. This year, the fund is up 0.93%, putting it about three percentage points ahead of the Standard & Poor's 500-stock index.
Kelmoore Strategy is saddled with high costs. Distributed through brokers, it charges a sales load of 5.5% on top of annual expenses of 2.25%. Dobson is a no-load fund with an expense ratio of 1.5%, only 0.09 percentage points higher than the average fund's. In 2000, the Dobson fund fared relatively well, rising 0.4%. So far this year, it is up 5.1%.
These funds are not exactly tax-efficient. The income is considered short-term capital gains and is taxed at ordinary income tax rates--not the more favorable long-term capital-gains rate. So fund shares are best owned in a tax-deferred account.
|Corrections and Clarifications In "How mutual funds come calling" (BusinessWeek Investor, May 21) Dobson Covered Call Fund misreported performance figures for year-to-date return. In the story and accompanying table, the correct figure should be -3.5%, not 5.1%, which is its return for April only.|
By Anne Tergesen