Two Options to Ride Out the Storm

10/02/2008 11:00 am EST

Focus: FUNDS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of ISA ETF Investor, says closed-end “buy write” funds are good investments in volatile markets.

Although we see the stock market in general as still vulnerable to a recession next year, the financial sector and certain closed-end funds represent attractive buys now.

With the federal government proposing to take over up to $700 billion of illiquid mortgage instruments, the large banks will see selling these instruments to the government represents a way of strengthening their balance sheets. Thus, money center banks, such as Bank of America (NYSE: BAC) and Citigroup (NYSE:C), would benefit the most from the bailout.

A second sector that should do well are income-oriented closed-end funds. The recent market has not been kind to these funds, and many are sporting double-digit yields and double-digit discounts to net asset value. This situation will not last.

We believe the “buy-write” strategy is the best way to take advantage of volatile markets. The main advantage is that in a down market, income is still generated by the option premiums, and they serve as a break during sharply declining markets.

The Eaton Vance Enhanced Equity Income Fund II (NYSE: EOS) is a closed-end fund employing the option-writing strategy. The fund is currently trading at $14.20 and yields 12.3%. The fund’s typical discount from net asset value over the past year was 6.54%, but it now trades at [more than] a 12% discount. (It was down 23% in the past year, as of last week—Editor.)

The fund seeks growth through capital gains and dividend income in addition to option income. [It] invests 27% of its funds in companies involved in information technology and 15% in health care companies.

International markets have followed the US market in the recent turmoil. As a result, option premiums have risen to match the volatility of the markets. There are many global “buy-write” funds that take advantage of high option pricing and that trade at discounts to their net asset value.

The ING Global Equity Dividend & Premium Opportunity Fund (NYSE: IGD) has the lowest expense and PE ratios and one of the highest yields compared to other [global “buy-write” funds]. It’s trading at a [roughly 20%] discount to its net asset value and yields 16.21%. (It was down almost 39% over the past year as of last week—Editor.)

The discount allows for a declining market and the promise of a 20% gain if the fund trades near its actual value. In addition to trading at a substantial discount, the difference between its current discount and its 52-week average discount is larger than other buy-write funds. The average discount over the past year was 5.19% compared to its current 20%. In addition to selling calls, the fund may also buy puts to protect against possible losses, an important safeguard in volatile markets.

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