How Covered Calls Can Boost Income

06/07/2012 7:30 am EST

Focus: FUNDS

Using covered calls with big-cap value names is the successful strategy used by fund manager Craig Van Hulzen. He also describes the fund’s methodology for identifying companies with established brand names and good position within their industries.

Kate Stalter: Today, our guest on The Daily Guru is Craig Van Hulzen of Van Hulzen Asset Management.

I wanted to talk first today about your Iron Horse Fund (IRHAX), which, as I understand, was just started last summer, a few weeks before the market went into freefall. So I wanted to start out by discussing not only the performance since then, but also the fund’s objectives and your investment philosophy.

Craig Van Hulzen: Sure, thank you. Yeah, as you mentioned, the fund did launch in the first week of July of last year, and the coveredcall strategy that we’ve been managing for ten years in our separately managed accounts. We did launch right into a market decline, but it’s a covered call strategy that is designed to, over the long term, and over a full business cycle, produce similar returns to the stock market, the S&P 500, but do it over time with less risk.

And the covered calls do two things for the strategy: They generate additional income over a dividend yield of a commiserate index, and they also work to decrease the day-to-day price volatility of the fund, relative to just a long-only stock portfolio.

Kate Stalter: I wanted to talk just a little bit more about the covered call strategy because it is something that maybe some of our listeners may not really quite be aware of. Now it does two things, does it not? It produces income, as well as provides some downside protection. Can you explain in some more detail how this works and why you’re using it?

Craig Van Hulzen: Yes. The long-term premise for the strategy is that when you look at the stock market for 100 years, or something in a very, very long time period, and you go back and disaggregate where a total return comes from, you quickly realize that around half of the total return in stocks historically have come from income, and the income being the dividend yield on stocks.

Only over the last 20 to 30 years have the dividend yields of major corporations fallen, and price-to-earnings multiples risen to higher ends of the historic range, so that more and more of the total return of stocks over the last 20 to 30 years have come from price appreciation. But historically it’s been much more even, and so there’s an underappreciation of the income component.

So our strategy is: It’s a bottom-up fundamental strategy, good rigid stock selection, but then when we select those stocks, we use the covered call as part of our exit strategy. So if we’re hopefully buying names that are undervalued, we are selling that call option where we think is the proper valuation for the company, and would be an exit strategy anyway.

That additional income that we collect from selling that call also acts as downside protection during periods where the market is moving in a sideways pattern or in a downward pattern. So historically the volatility of the strategy is less than that of a similar stock portfolio, and especially during periods of sideways and downward markets, the strategy has the tendency to have its greatest outperformance.

Kate Stalter: Are you finding that individual investors are developing more of an appreciation for these type of strategies with the volatile markets that we have had? Because traditionally it’s been kind of income versus growth in a plain vanilla sense, but you’re talking about some additional elements that could enhance performance. Are retail investors understanding these strategies more these days?

Craig Van Hulzen: Well, I think what retail investors are inherently doing, and what we see investors doing individually, is searching anywhere, high and low, for income. With the current Fed policy and the zero-interest-rate policy, almost no income from money markets, cash, or CDs, a ten-year bond at 1.5%, dividend yield on stocks of 2%, we see a lot of retail investors searching for income.

And we think they have really, two choices: They’re either going out and trying to find real estate or high-yield income that’ll offer more of that cash flow stream, and taking on more credit risk, or learning about covered calls and having a high-quality investment portfolio and group of holdings, and increasing their income through the selling of calls. So I think there’s some education going on at the retail level as people are looking for income.

Kate Stalter: I wanted to also talk a little bit about the composition of the fund. I was looking at some of the Morningstar data, which listed some of the holdings, at least as of the most recent quarter, and I did notice several Dow components, other dividend-paying blue chips. Although I did see Google (GOOG) was also in there, which would probably be considered more in the large-cap growth category. How do you determine the composition of what you’re buying for the fund?

Craig Van Hulzen: Well, each holding that we’re looking for, we’re looking for certain characteristics or qualities.

Like I said earlier, we are a bottom-up fundamental stock selector, in addition to being a covered call manager. So the first step of the process is really a cash flow return-on-investment model, where we’re looking for the current valuation of a good, solid company relative to its future, like a lot of stock managers would.

So most of our holdings tend to be in that large-cap value, according to Morningstar, because they are dividend payers, and they’re low-leverage, high cash flow, established brand names—those sorts of things. But even though Google does not pay a dividend, and a few other names like Google in the portfolio do not pay a dividend, they do meet all of the value criteria: Brand, positioning in their industry, and some of those key metrics that drive our fundamental decision.

Kate Stalter: Where do you see this fund as fitting in with an investor’s overall portfolio?

Craig Van Hulzen: When we talk to investors, and really work through asset allocation and where to place it, we see a lot of match in two areas. One, a replacement for a large-cap value or a large-cap blend long-only fund. This works really well from a correlation and from a standard deviation standpoint, if you’re putting certain funds together in the US equity space. It’s a nice addition.

And then another category, which maybe is a little less straightforward, but people who would otherwise allocate into, say, high-yield bonds or a convertible preferreds, or that sort of category, also can use this fund in that allocation.

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