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Juice up income with new Wall Street wrinkle

Richard Loth

Our friends in the mutual fund business in lower Manhattan have come up with yet another innovation, “option strategy funds,” that will be of interest to income investors. First, let’s start with the reason why these funds have come into play. As an investor looking for income, you basically have three investing choices: dividend-paying stocks, bonds, and income-oriented mutual funds. Buying individual stocks and bonds directly requires a relatively large amount of capital and investment know-how. For the average individual investor seeking income, mutual funds have been the practical option.However, in recent years, the yields on income-oriented funds have been rather modest. Bond funds do a poor job of protecting principal against the effects of inflation. In general, unless a mutual fund has very low expenses, it is disadvantaged because it must use its income generation (dividends and/or interest) to cover operating expenses. Therefore, during the course of this year, a growing number of fund companies have come up with what appears to redress the income-inhibiting features of the conventional mutual fund. Wall Street Journal reporter, Tom Lauricella, reported on this innovation in his Sept. 23 article, “New Ways to Get Growth and Income Pop Up as Aging Investors’ Needs Shift.”Lauricella describes two vehicles: “One type buys dividend-paying stocks but is structured as a low-cost exchange-traded fund (ETF) … so it can pass along more of the dividend income it collects to shareholders than a traditional fund. Another buys dividend-paying stocks and also sells options to generate income of 8 percent to 10 percent or more.” It is this latter type of fund with the options strategy that is attracting the attention of income investors.Here is how these funds operate. The most common format is to create a closed-end fund that sells a fixed number of shares to the public and invests the proceeds in a variety of high dividend-paying stocks. Subsequently, the fund lists on an exchange, generally the New York Stock Exchange, and becomes an exchange-traded fund that trades like a stock. In addition to stock dividends, the portfolio manager enhances the fund’s income from fees, also referred to as premiums, generated from selling options (covered calls) to other investors. This may sound somewhat exotic, but selling covered-call options is actually considered a fairly conservative investing strategy. In the case of an options strategy fund, you can rest assured that experienced professionals are handling these transactions.Lauricella’s article highlighted four option strategy funds with annualized yields, based on the latest monthly dividend, averaging around 9.25 percent. These funds all had start-ups in 2005, leading a Lipper Inc. research analyst to observe that option strategy funds “are fairly new, so we can’t yet be sure what rates might be sustainable.”A prospectus for these funds runs some 70 pages and, even if you’re up to reading one, it isn’t going to be that enlightening. Understandably, as yet there’s virtually no independent research information available on any of the funds in this new category. My advice for interested investors would be to call the fund managers directly for a firsthand report. Here’s the contact information:• Eaton Vance Tax-Managed Buy-Write Opportunities (ETV) 1-800-225-6265• ING Global Equity Dividend & Premium Opportunity (IGD) 1-800-992-0180• NFJ Dividend, Interest & Premium Strategy (NFJ) 1-800-331-1710• Nuveen Equity Premium Opportunity (JSN) 1-800-257-8787Just remember, as Lauricella points out, that “income generated by the options strategy can vary depending on the amount of volatility in the stock market.” And while stock market volatility scares most investors, options traders love it – the “greater the expected ups and downs, the more a fund can collect for selling an option.”The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing and an independent registered investment adviser. Loth can be reached at 328-5591 or mentor@centurytel.net.Vail, Colorado


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