One option for better yields? Funds that sell options

Investors have left few stones unturned in the attempt to find sources of reliable investment income in a world of persistently declining government-bond yields.

One could even argue that income-craving buyers are trying to squeeze blood from those financial stones after they’ve kicked them over. Riskier corporate bonds, exotic mortgage securities, utility stocks, real estate investment trusts, pipeline limited partnerships, bank-issued subordinated preferred stock – all have become unattractively valued due to voracious demand and the global scarcity of yield.

With these more-traditional assets, the lure of consistent cash income comes with at least one of two risks. Longer-term debt incurs “duration risk,” or the chance that a general rise in interest rates in years to come will cause the bonds to lose value in the market. Equity vehicles such as REITs and utility shares are vulnerable to broader downturns in the stock market and their industry sector, or to individual corporate stumbles.

Decent income, less crowded 

Some creative money managers, though, are collecting decent income in less crowded parts of the market without adding much risk, by selling options in a disciplined way to make a bit more cash.

One distinctive alternative to plain short-term bond funds is the Kinetics Alternative Income fund (KWINX), which early last year undertook a strategy of holding short-duration investment-grade bonds and then selling far out-of-the-money put options on blue-chip stocks and exchange-traded funds to enhance income.

Put options give the buyer the right to sell a stock at a preset price by a certain date. The seller of the put collects the cash premium paid, which he or she keeps unless the stock falls below the set strike price by the expiration date.

The Kinetics fund sells put options that are struck well below a stock’s current price, 25% or 30% out of the money in many cases. The puts sold therefore have a high probability of expiring worthless, allowing Kinetics to keep the cash and lift the fund’s cash yield without taking on the added duration risk of buying longer-term debt or the credit risk of owning junk-rated bonds.

The results have been pretty good since the fund undertook this approach in early 2013. So far this year, its total return is 2.28% through Thursday, compared to 0.98% for the Barclays 1-3 Year Credit Index. In the year through March 31, Kinetics Alternative Income delivered 4.04% versus 1.50% for the same benchmark. (As a bonus, the fund was converted from a stock-picking portfolio that had racked up losses in the bear market, so the current fund has tax-loss "carryforwards" that can offset taxable income for current fund shareholders for a while.)

A sober method of sweetening income

Selling puts is certainly risky in its own way. It can require the seller to buy stock at above-market prices in a market that’s cascading lower, for relatively little cash compensation up front. But selling far out-of-the-money puts on relatively stable stocks, against the collateral of a conservative bond portfolio, is a reasonably sober method of sweetening cash income. It can be viewed as operating an insurance business – collecting risk premiums from buyers who want protection while sitting on a portfolio of safe bonds.

A recent Goldman Sachs study suggested that use of options by mutual funds has become a bit more mainstream. At least 196 funds overseeing a total of nearly $500 billion incorporated options into their strategies, and as a group over the prior five years, they produced higher returns, lower volatility and better risk-adjusted returns than their peers who didn’t.

Academic research has shown that aggregate hedge fund returns – lagging in strong up-markets but providing steady results and good risk-adjusted returns in sloppier environments – most closely track a simple put-selling strategy. Of course, an investor could execute such a put-writing practice on his or her own without paying for hedge-fund managers' vacation homes and kids' tuition with heavy fees.

CBOE Holdings’ (CBOE) maintains the CBOE S&P 500 PutWrite Index (^PUT), which simulates the sale of one-month, at-the-money puts on the S&P 500 index while holding the cash in a money market account. These tend to be in strong demand by hedgers, delivering steady income to put sellers over time. Of course, such a put seller takes on the risk of a market meltdown and gives away much of the potential market upside.

There has been a smattering of retail investment products that offer access to more aggressive, but systematic, put-selling techniques.

One is an exchange-traded fund run by ALPS Advisors, the U.S. Equity High Volatility Put-Write Equity Fund (HVPW), which launched in February 2013. This fund tracks the NYSE Arca U.S. Equity High Volatility Put-Write Index, selling out-of-the-money puts on the 20 most volatile large-cap stocks at any given time, rejiggering the basket of stocks every two months.

The fund distributes the cash from the put sales bimonthly as well, seeking to dispense 1.5% of its net assets each 60 days. If the fund’s investment income isn’t sufficient to cover that level of payout in a period, the distribution could be classified as a “return of capital” for tax purposes, potentially complicating a holder’s tax situation. The fund’s fees are also fairly steep, at 0.95% a year, though certainly an individual couldn’t easily replicate the strategy at such a low cost.

In general, simple solutions beat complex ones when it comes to investing for income. But extreme low levels of interest rates on low-risk paper might inspire investors to consider some “engineered solutions” to this conundrum. They should just be sure to know what they’re buying, and avoid any strategies that appear to stretch beyond sober risk-minded cash-collection toward promises of elusive world-beating returns.