IVV iShares Core S&P 500

Although stocks have begun the new year on a high note, many investors remain uncertain about the market nonetheless. Weaker than expected earnings at some firms and continued concerns over the health of key markets such as China and Europe could weigh down securities throughout the first quarter of the year. In light of this, some investors have taken to strategies that allow investors to stay allocated to the market but that could offer some level of downside protection as well.

One such technique that is often used to accomplish this goal is what is known as the ‘Buy Write’ strategy. This method involves buying a security—or basket of securities—and then writing (selling) out of the money—or close to in the money-- covered calls on the recently purchased asset. When an investor sells the call, they receive a premium no matter what happens with the underlying security. If the product stays flat or declines slightly, investors keep the premium and their stock. However, if prices rise, investors only receive the premium and the stocks are sold at the price that was agreed upon in the covered call (also read Convertible Bond ETFs Head-To-Head).

This strategy can help to generate income for investors in some markets and it can also assist in protecting principal as well. Furthermore, it could help to keep investors disciplined as it promotes selling stocks when they are at an elevated price instead of just chasing higher returns. For those who are curious about implementing this technique on the broad markets but are unfamiliar with the world of options, two ETPs could be an excellent choice instead. In this space, investors have two options in order to gain exposure; iPath CBOE S&P 500 BuyWrite ETN (BWV) and PowerShares S&P BuyWrite Portfolio (PBP).

Buy-Write ETFs In Focus

Both funds seek to give investors the ability to implement a buy-write strategy in their portfolios by using the technique with the S&P 500. The ETPs look to purchase in the money or slightly out of the money calls on the S&P 500 every month, generating a nice cash flow on a regular basis. While they are generally similar, there are a few key differences that investors should be aware of. First, PBP is an ETF which means that tracking error is a possibility but there is no credit risk for investors. BWV is exactly the opposite; the product is structured as an ETN and it has no tracking error but credit risk from the issuing institution, Barclays (see ETFs vs. ETNs: What’s The Difference?).

Yet, while the strategies employed may be both interesting and offer higher yields, investors should note that when the market surges in a short period of time gains can be limited as the covered call strategy does sacrifice some of the upside for these payouts. Additionally, the fees are very high when compared to broad market funds that do not implement these strategies. In fact, both charge 75 basis points a year for their services, a hefty premium over pure S&P 500 ETFs such as IVV and SPY which charge less than ten basis points a year in fees. Thanks to these issues, many investors are likely wondering if these hefty premiums are actually worth it in the total return department (read Ten Best New ETFs of 2011).

When one looks at the performance of PBP or BWV and their price return compared to a fund like SPY, a trend of underperformance appears to develop. In fact, over the past year, PBP has lost about 5.1% while SPY has gained about 1%, solely when looking at price. Yet, when dividends and the hefty cash payouts are included, a more balanced picture results when comparing buy-write funds to their optionless counterparts. From January 18^th 2011 to January 17^th 2012, PBP added 5.2% while SPY has gained just 4% in comparison.

So, when investors just compare the price return of buy-write funds to their non-options using counterparts they are likely to be disappointed but when a closer inspection is taken, a history of outperformance appears. Investors need to keep this in mind when considering a purchase in the space as the dividends make up a huge component of these ETPs and their strategies (read Three Bond ETFs For A Fixed Income Bear Market).

However, with that being said, it should also be noted that these buy-write products have much more variable payouts than their counterparts like SPY which can always be counted on for pretty consistent dividends. For example, of the last eight regular dividend payouts for PBP, the range was from 2.7 cents a share up to a whopping $1.84 a share. While the $1.84 was largely an outlier, dividends did still vary wildly and capital gains were given out to investors in each of the past two years as well.

So if investors can stomach this volatility in payouts and the higher fees, buy-write funds like PBP and BWV could be excellent choices. Just make sure to remember that the funds can underperform when markets are surging and that total returns including dividends need to be considered in the space. Lastly, a surging market probably isn’t ideal for these products but a flat or declining one could help to soften the blow thanks to the outsized payouts that are often inherent in these types of strategies.

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