Option Income Funds: Watch Out

Their payouts are generous in these low-yield times, but the risks are great

Despite the Federal Reserve's determination to raise interest rates, bond yields remain stuck at low levels -- a big problem for income-oriented investors. Dividend-paying stocks yield even less. So perhaps it's no surprise that brokerage firms have revived an old concept called option income funds. These funds buy stocks and sell, or "write," options on them, pocketing the payments, or "premium." With that income, some funds are already yielding 8% to 10%, which looks awfully inviting in today's low-income environment.

So far this year, Wall Street has raised $8.7 billion for 14 closed-end "buy-write" or "covered call" funds that use this strategy -- and nine more are in the pipeline. Is this a bubble that will end badly or a genuinely good deal? That depends, in part, on investor expectations and the way the funds are managed.

Anyone buying these as a bond-fund substitute could be in for surprises. The underlying holdings are stocks, which are more volatile than bonds and have a greater risk of losing some of your principal. "When rates are low like they are now, the only way you're going generate more income is to take a lot more risk," warns Mitch Dynan, chief investment officer at Mintz Levin Financial Advisors in Boston. Option-writing strategies "are a decent way to get some income, but I wouldn't look at it as an alternative to fixed income."

Stock investors, starved for dividends, may like the funds' plump payouts, but there could be some disappointments for them, too. Selling calls wins big when markets are sluggish, as they've been this year. The option premiums keep rolling in, and a fund's stocks never get called away because prices are flat. But the strategy lags far behind ordinary stock funds and even dividend-oriented funds when the market rallies. In essence, an investor is trading the big gains that stocks sometimes see for higher current income.

In the 1980s, option-writing funds suffered from poor stock selection. "The early funds ran into difficulty by looking for whatever stock could deliver the most premiums without concern for the underlying portfolio that was created," says Ronald Egalka, president of Rampart Investment Management, which is co-managing several of the new funds.

This time around, fund companies are saying they'll manage with more concern for equity performance and some are using an independent manager to run the option portion of the portfolio. With the Eaton Vance Enhanced Equity Income II Fund (EOI ) (EOS), managers pick the stocks while Rampart writes the options. Egalka says his computer model adjusts the amount of options sold to preserve more upside potential, but the trade-off is somewhat less downside protection.

Various funds are taking different approaches. Merrill Lynch's Enhanced Equity Yield Fund (EEF) will buy dividend-paying stocks and sell only index options, not options on individual stocks. The NFJ Dividend, Interest & Premium Strategy Fund (NFJ) diversifies by adding in dividend-paying stocks and convertible bonds. The BlackRock Global Opportunities Equity Trust (BOE) buys stocks and sells options all over the world.

If you're interested in a covered-call fund, resist the brokers' pitches to get in on the next big initial public offering. Better to buy one of the older members of the class of 2005 -- or even one of the few that launched last year. For starters, the newest funds haven't yet set their payout rates, while older ones have. The other problem with new funds is that the underwriting fee, which can be as high as 7%, is embedded in the price. Older closed-end funds have already sold off to reflect that -- and then some. Why pay retail if you can buy at a discount?

By Aaron Pressman

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