What is a Buy-Write Fund? Can a Buy-Write Fund Provide Income?

Today I was looking at the prospectus for the PowerShares S&P 500 Buy-Write Portfolio (symbol PBP).  This is a buy-write fund that buys shares in the companies in the S&P500 index and then writes covered calls on those shares for the next month at the next highest strike price.  They attempt to match the performance of an index created by the Chicago Board Options Exchange (CBOE) called the “CBOE S&P500 BuyWrite Index.”  Of course, the index has no fees or trading costs, while the index fund does, so the buy-write portfolio will never quite match the performance of the index.  Still, the fees aren’t that outrageous, coming in at about 0.70%.  The trading costs are necessarily high since they must write options each month.

(For those unfamiliar with options, a call is a contract in which you agree to sell your shares for a specified price, called the strike price on or before a certain date, called the expiration date.  In return, you receive some cash called a premium.  If the shares are at or above the strike price when the expiration date comes, they will normally be bought buy the person who bought the contract from you.  If not, the contract will normally expire worthless and you get to keep the premium.)

PBP has done poorly relative to the S&P500 Index.  This is because the index has been on a tear lately, shooting up in price and making new highs.  When this happens, the index fund managers need to buy back the calls at a loss each month, so while they make some money on the increase in the value of the shares, they don’t make as much as they would have if they had just held the shares.  Therefore the fund has a positive return but they don’t do as well as the underlying index.

The performance, however, from 2007 until 2012 was right in line with that of the S&P500 index or even a bit better at times.  For example, during the 2008-2009 period the S&P500 index fell by about 50% while PBP only fell by about 30%.  This is because the premiums they were collecting from the options were offsetting the decline in the value of the shares.  They would also do a lot better than the index in periods where the stock market was essentially flat or trading within a range since they would be collecting option premium payments all of the time that the index was going nowhere.   Also, the greater the volatility, the greater the price of the options that would be sold.

One question is whether such a fund would be a good replacement for something like a bond fund for steady interest since there is cash generated by the options being sold.  It does not look like a good time to buy bonds with interest rates ready to increase if the economy ever starts to improve and the Federal Reserve ever takes their boot off of the neck of short-term rates.  In addition, bond rates are barely worth the money since they are so low.

PBP returned about 9% over the last year and 7%+ annualized over the last three years.  Looking back further, the performance is even better, with an annualized return of over 10% during the last five years.  The S&P500 index did much better over the period, providing an annualized rate of return of over 19% for the period, but the Vanguard Total Bond Market ETF only returned 4.7% annualized over the last five years.

Obviously when you are getting a better return, you are taking more risk.  While a buy-write portfolio is safer than buying stocks outright, they have risks that bonds don’t have.  With a bond, assuming the company issuing the bond is able to repay their loan to you at the maturation date of the bond, you will get the par value no matter what the price of the bond does in the mean time.  With a buy-write portfolio, there is nothing to say that the stocks on which the calls are written won’t fall through the floor and stay down for a period of time.  Stocks like those in the S&P500 aren’t likely to go down forever (and if they do, you’ll have a lot of other things to worry about because the US economy will basically be gone), but they could take a nasty spill just when you need the money if you have too much invested right before retirement or another life event.

Still, with bonds looking so pricey and so risky, a buy-write portfolio might be a good place to look.  There will be some protection from inflation since the fund will hold equities, although not as good a protection as holding equities only would have.  It also can provide an income, and you will be making money even when the stock market is stagnant.  It will also decline less than the stock market during downturns as we saw back in 2008.  PBP, or perhaps another buy-write fund may deserve a place in your portfolio.

I will consider buying in with my IRA this year.   Note that an IRA is the place to have interest and dividend generating stocks since the income produced will be taxed each year in a standard account even if you reinvest the dividends.  This type of fund will go nicely with my other income generating assets like my REIT funds.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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