Lipper Research Analyst Don Cassidy on "Business for Breakfast" 1060 KRCN

Tuesday, June 7, 2005

A. Sure, and we probably need to include an explanation of writing calloptions.

Q. Definitely...

A. These covered-call funds have been created and marketed in response totwo factors:

1. people are scared of losing money (since the bubble popped) andthey very much like current income in hand.
2. some people see the general market going sideways and want tofind a way to increase their returns.

Q. And these funds fit those needs?

A. Well.... sometimes. And it heavily depends on what the market does. Theincome part of the equation, yes, that fits. But they certainly don'tprovide total downside protection.

Q. OK, so back to "writing" calls....

A. Right. If you own a stock, you can sell an option against it, whichgives the buyer of the option the right to "call" your stock away from youat a pre-determined price on or before a specified date. You receive moneyup front for writing that option, and the buyer of the option PAYS for thatprivilege. The more time you write the option for, the more you get paid.The more volatile the stock is, the greater the premium too.

Q. So if you write an option, you hope the stock does not go up??

A. Right, at least in the near term. Ideally you want the option to expireworthless and not be exercised. So you'd keep your stock and the money yougot paid for the option.

Q. And so mutual funds are doing this now?

A. Right. The attraction is that the fund collects the option premiums,which adds to the dividends it will collect on its portfolio and therebyallows the fund to pay out a higher cash-income return. People like theextra cash yield.

Q. Are there a lot of funds doing this?

A. It has become a little mini trend, yes. Actually, the most popular andpractical way to do it is with a closed-end fund. And there have been anumber of those created in the past year or so. With a closed-end, theportfolio manager does not worry about new cash flowing in (or out) and canset up the stock/option positions and not worry about needing to disturbthose holdings due to money flow.

Q. Are there downsides to this?

A. Almost anything you can think of on Wall Street is not a one-way streetor a free ride! In this case, I would say the two major issues investorsneed to think about are: 1- you will under-perform by a lot if the market decides to go on asustained rally 2 - the nature of the fund is that it will be very tax-INefficient,so you'd want to put it into an IRA or similar plan if you can.

Q. Can you explain those aspects a little?

A. When you buy stocks and write options, ideally you want the stock (orthe market) to end up about where you started, so the time value of theoptions you wrote melts away and the stock does not get taken away fromyou. If the market goes up, your stocks will get called away and you willneed to buy them again, or sell other options, or buy back your writtenoptions at a loss. All of that involves high turnover and commissionscosts. And you do not get the full upside ride on the stock prices!

Q. And that's what makes it NOT tax efficient?

A. Correct. Probably most of the stocks held will be called away beforethey are held for one year, so the gains will be short-term and taxable atthe full rate. Or if the market goes down, the stocks are not called awaybut you (the fund) will have a paper loss. And the expired premiums areregular income, and if the fund buys back the options to prevent the stocksfrom being called away, any gain on the option is regular income. So it isnot great for a person's taxable personal account, especially in the upperbrackets where many sophisticated investors tend to be.

Q. Would you generally think of these funds as conservative, or aggressive,in nature?

A. I guess I'd say on the conservative side of middle. You DO get moreincome, and if the market goes down your net losses will be smaller becauseyou collected the premiums. But you are definitely limiting yourself onthe upside if the market rises. Somewhat like buying stocks for yieldinstead of for growth, if a nice bull market comes.

Q. Risks?

A. One risk that makes such a fund potentially NOT conservative is that thebiggest premiums are available on the most volatile stocks, so if themarket falls then you have greater-than-average downside price exposure ?IF the portfolio manager stretches to get the extra premiums on suchstocks.

Q. Do funds like these tend to come out in sort-of "cycles"?

A. Deep in history we noted that some of these came out briefly in the1970s. But the current new cluster IS part of a pattern: Wall Streetcreates funds that appeal to current taste. In 1999 it wastechnology/telecom funds. In 2002 it was so-called principal-protectionfunds when people were scared. In 2003 and 2004 a lot of real estate andnatural resources funds came out, when those areas got real hot. In 2004 alot of dividend-paying-stock funds were created, because people loved thenew lower tax rate. And now these covered-call funds play to the sensethat the market may not go very far in either direction, as it has beendoing for much of the past 16 months.

Q. So, bottom line, do you recommend people consider, or avoid, them?

A. That depends on what bet you want to make on the market. If you arepretty bullish, I don't see them as a great choice: you are trading for alittle more income by giving away upside appreciation potential. And ifyou DO like them, please understand the market bet you are making... ANDput them in a tax-sheltered account.

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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).