The use of covered call options is boosting total return and drastically reducing volatility in a little-known large-cap value fund managed by Neiman Funds Management LLC.
In addition to outperforming the S&P 500 this year, the Neiman Large Cap Value Fund Ticker:(NEIMX) stands out as having the second-lowest volatility rating of the more than 1,200 domestic large-cap value funds tracked by Morningstar Inc.
When the universe is expanded to include the more than 9,000 domestic equity funds tracked by Morningstar, the Neiman fund has the eighth-lowest volatility rating, as measured by standard deviation.
The key, according to portfolio manager Harvey Neiman, is the application of call options across the concentrated portfolio of about 40 stocks.
The call options, which are sold on about 30% of a stock's total weighting in the fund, produce added income that Mr. Neiman describes as a “dividend enhancement” because of the guaranteed and immediate impact on total return.
Selling a call gives the option owner the right to purchase the underlying stock at a future date for a pre-determined price, regardless of what the stock's price is at that time.
As an example of how Mr. Neiman uses the strategy, he sold call options on shares of McDonald's Corp. Ticker:(MCD) on March 31 when the stock was trading at $67.04 per share.
He made $1.51 per share by selling options set to expire Sept. 17 with a $72.50 strike price, or the price at which the option holder could purchase the stock at any point prior to the expiration of the option.
The stock traded above the strike price for most of September and the option was exercised, resulting in a $5.46-per-share capital gain.
But in addition to the $1.51 worth of option income, McDonald's also made two dividend payments over the period totaling $1.10 per share.
It all adds up to a total gain of $8.07 per share, or 12% between March 31 and Sept. 17.
While it is true that McDonald's stock climbed beyond the strike price that Mr. Neiman earned, he shrugged that off as a part of the strategy and, in fact, embraces it as a built-in sell discipline.
“With the option, you don't have a choice of when you want to sell the stock,” he said. “The bad news is that the stock price was higher when we sold it at the strike price, but the strategy does introduce a sell discipline.”
Mr. Neiman recognizes the limits that call options place on upside potential, which is why he only sells calls on one-third of his total position in any stock.
Instead of looking at the upside limits, he prefers to think of the option as downside insurance, treating the option income as a mechanism for lowering the initial purchase price.
In the case of McDonald's, for example, the $1.51 in immediate income for the call sale reduced his investment cost from $67.04 to $65.53.
Year-to-date through October, the fund was up 8.3%, compared with a 6.1% gain by the S&P over the same period.
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