Magic Dividends Impress the Experts, MAXfunds Not So Much
April 8, 2007
We live in a world of single-digit yields. No mutual fund is earning a legitimate 10%+ yield today, but that doesn’t stop some fund companies from pretending that they do.
In such a underwhelming investment environment, you can imagine investors’ surprise last week when Forbes.com launched a video entitled “BlackRock's Dividend Machine,” in which BlackRock Enhanced Equity Yield & Premium Fund (ECV), a closed-end fund, reported a double-digit yield. The video is a follow-up to a previous article entitled “Eye-Opening Yield In A Closed-End Fund." Not surprisingly, the fund shot up 1.7% after the video was posted.
The fund is now trading at an approximate 11% premium over net asset value (NAV). In other words, investors are willing to pay $1.11 for $1.00 worth of the fund. And why not? As the article notes, "the fund’s current payout is $2.05 per share, for a yield of 10.06%."
So how is such an eye-opening yield generated? Certainly not from stock dividends. The S&P 500 is currently yielding less than 2%. The fund’s top five holdings, Microsoft (MSFT), ExxonMobil (XOM), General Electric (GE), Qualcomm (QCOM), and Intel (INTC), are the stuff of 2% dreams, not 10%. Besides, the fund’s 1.11% expense ratio would eat up at least half of the dividends collected from the fund's stock holdings.
In fact, the extra yield is actually the result of option writing. Selling, or "writing" call options is a way to earn income by selling off the upside of a stock. The safest way to use options is to sell calls on stock already owned - that way, if it goes up 100%, the option seller can just hand over the appreciated stock.
In contrast, ECV writes naked (uncovered) S&P 500 and S&P 100 Index options that the fund can then settle in cash instead of delivering the underlying stock. The fund owns a similar basket of stocks with a high correlation to these indexes, so their risk is minimal. In most scenarios, this fund would be safer than a regular index fund (about a 10-15% lower risk in a big market drop).
There is a cost for this income and reduced downside, however. The fund will probably never have the upside of a stock fund. In general, option writing strategies allow investors to earn non-bond income. They're particularly effective when stocks go sideways for long periods of time but still demonstrate enough volatility to keep option premiums rich.
Unfortunately, the story is out on option writing. There are now dozens of closed-end funds grinding out yields by selling options. That makes it hard to get a juicy yield going. In fact, in a moderately strong market, investors are likely to see option “premiums” turn into option losses that will have to be settled when those options expire.
In an up market like last year's, investors could expect to earn about 10%, which is quite a bit less than the 15%+ that the S&P 500 delivered. So is that what the fund paid out last year? The 10% return from writing options and collecting dividends? Nope.
Imagine that you bought Microsoft stock at $20 per share and simultaneously sold a call option on the S&P 500 for $2 in proceeds on each unit. If Microsoft rose to $24 and the S&P 500 gained, your $2 index option premium would then turn into a $4 liability, and you'd have to settle up with the option buyer in cash, representing a $2 loss. However, you’d still be up $4 on MSFT, so you would’ve really made $2, or 10% (not the 20% that you would have earned had you bought MSFT outright). If you didn’t sell all of your Microsoft shares to pay the option buyer, you wouldn’t have much of a realized gain.
By law, mutual funds have to pay out all of their realized taxable gains and income - that's why they're not taxed like other companies (shareholders are taxed on distributions instead). But there's no law that says the fund can’t pay out MORE than their taxable gains and income. Doing so is really just handing investors their money back – a non-taxable event. This creates the illusion of a regular, artificially large dividend.
Apparently this magical high-yield fund executed a lot of trades like our Microsoft example, because most of ECV’s 2006 distributions just paid shareholders their money back. Of the bold $2.05 per share paid out last year, a whopping $1.21, or 60%, was a “non-taxable return of capital.”
Is this just nitpicky tax stuff? The fund’s NAV was up 11% in 2006 - they just paid it all out as income, right? Wrong. Lots of funds were up 11% (or more) in 2006. Many paid dividends of a few percent. Unless the funds realized gains of over 10%, they didn’t pay out cash to match their returns. Bottom line - this fund does not yield 10%. It actually lost money on the option writing and just made more on the stock positions.
A similar open-end fund that we’ve recommended in the past (and that we own, both personally and in our model portfolios) is Gateway (GATEX). This lower-risk fund was up 10.15% in 2006. Unlike the more expensive ECV, Gateway didn’t pay distributions in 2006 of 10%. Instead, the dividend was about 1%. Of course, investors could have sold some of their GATEX shares if they'd wanted 10% in “income."
Those who want the income opportunities that come from option writing are better off with GATEX, which, like all open-end funds, trades at NAV, not at a premium to NAV like BlackRock Enhanced Equity Yield & Premium Fund. Someday, ECV will fall back to a 10% discount to NAV when the spotlight is off of option writing. Investors could conceivably lose as much buying ECV at a 10% premium and selling at a 10% discount as they could in any other S&P 500 Index fund.
For the record, in our 2006 HotSheet (free to subscribers of the MAXadvisor Powerfund Portfolios) we recommended NFJ Dividend Interest & Premium Strategy (NFJ), a similar option writing closed-end fund that was better, had lower fees, and had been trading at a deep discount to NAV. NFJ is no longer as much of a bargain, but it's still a much better deal than the BlackRock fund in fees, performance, and premium to NAV.
Magic Dividends Impress the Experts, MAXfunds Not So Much
We live in a world of single-digit yields. No mutual fund is earning a legitimate 10%+ yield today, but that doesn’t stop some fund companies from pretending that they do.
In such a underwhelming investment environment, you can imagine investors’ surprise last week when Forbes.com launched a video entitled “BlackRock's Dividend Machine,” in which BlackRock Enhanced Equity Yield & Premium Fund (ECV), a closed-end fund, reported a double-digit yield. The video is a follow-up to a previous article entitled “Eye-Opening Yield In A Closed-End Fund." Not surprisingly, the fund shot up 1.7% after the video was posted.
The fund is now trading at an approximate 11% premium over net asset value (NAV). In other words, investors are willing to pay $1.11 for $1.00 worth of the fund. And why not? As the article notes, "the fund’s current payout is $2.05 per share, for a yield of 10.06%."
So how is such an eye-opening yield generated? Certainly not from stock dividends. The S&P 500 is currently yielding less than 2%. The fund’s top five holdings, Microsoft (MSFT), ExxonMobil (XOM), General Electric (GE), Qualcomm (QCOM), and Intel (INTC), are the stuff of 2% dreams, not 10%. Besides, the fund’s 1.11% expense ratio would eat up at least half of the dividends collected from the fund's stock holdings.
In fact, the extra yield is actually the result of option writing. Selling, or "writing" call options is a way to earn income by selling off the upside of a stock. The safest way to use options is to sell calls on stock already owned - that way, if it goes up 100%, the option seller can just hand over the appreciated stock.
In contrast, ECV writes naked (uncovered) S&P 500 and S&P 100 Index options that the fund can then settle in cash instead of delivering the underlying stock. The fund owns a similar basket of stocks with a high correlation to these indexes, so their risk is minimal. In most scenarios, this fund would be safer than a regular index fund (about a 10-15% lower risk in a big market drop).
There is a cost for this income and reduced downside, however. The fund will probably never have the upside of a stock fund. In general, option writing strategies allow investors to earn non-bond income. They're particularly effective when stocks go sideways for long periods of time but still demonstrate enough volatility to keep option premiums rich.
Unfortunately, the story is out on option writing. There are now dozens of closed-end funds grinding out yields by selling options. That makes it hard to get a juicy yield going. In fact, in a moderately strong market, investors are likely to see option “premiums” turn into option losses that will have to be settled when those options expire.
In an up market like last year's, investors could expect to earn about 10%, which is quite a bit less than the 15%+ that the S&P 500 delivered. So is that what the fund paid out last year? The 10% return from writing options and collecting dividends? Nope.
Imagine that you bought Microsoft stock at $20 per share and simultaneously sold a call option on the S&P 500 for $2 in proceeds on each unit. If Microsoft rose to $24 and the S&P 500 gained, your $2 index option premium would then turn into a $4 liability, and you'd have to settle up with the option buyer in cash, representing a $2 loss. However, you’d still be up $4 on MSFT, so you would’ve really made $2, or 10% (not the 20% that you would have earned had you bought MSFT outright). If you didn’t sell all of your Microsoft shares to pay the option buyer, you wouldn’t have much of a realized gain.
By law, mutual funds have to pay out all of their realized taxable gains and income - that's why they're not taxed like other companies (shareholders are taxed on distributions instead). But there's no law that says the fund can’t pay out MORE than their taxable gains and income. Doing so is really just handing investors their money back – a non-taxable event. This creates the illusion of a regular, artificially large dividend.
Apparently this magical high-yield fund executed a lot of trades like our Microsoft example, because most of ECV’s 2006 distributions just paid shareholders their money back. Of the bold $2.05 per share paid out last year, a whopping $1.21, or 60%, was a “non-taxable return of capital.”
Is this just nitpicky tax stuff? The fund’s NAV was up 11% in 2006 - they just paid it all out as income, right? Wrong. Lots of funds were up 11% (or more) in 2006. Many paid dividends of a few percent. Unless the funds realized gains of over 10%, they didn’t pay out cash to match their returns. Bottom line - this fund does not yield 10%. It actually lost money on the option writing and just made more on the stock positions.
A similar open-end fund that we’ve recommended in the past (and that we own, both personally and in our model portfolios) is Gateway (GATEX). This lower-risk fund was up 10.15% in 2006. Unlike the more expensive ECV, Gateway didn’t pay distributions in 2006 of 10%. Instead, the dividend was about 1%. Of course, investors could have sold some of their GATEX shares if they'd wanted 10% in “income."
Those who want the income opportunities that come from option writing are better off with GATEX, which, like all open-end funds, trades at NAV, not at a premium to NAV like BlackRock Enhanced Equity Yield & Premium Fund. Someday, ECV will fall back to a 10% discount to NAV when the spotlight is off of option writing. Investors could conceivably lose as much buying ECV at a 10% premium and selling at a 10% discount as they could in any other S&P 500 Index fund.
For the record, in our 2006 HotSheet (free to subscribers of the MAXadvisor Powerfund Portfolios) we recommended NFJ Dividend Interest & Premium Strategy (NFJ), a similar option writing closed-end fund that was better, had lower fees, and had been trading at a deep discount to NAV. NFJ is no longer as much of a bargain, but it's still a much better deal than the BlackRock fund in fees, performance, and premium to NAV.