Neiman Large Cap Value Fund (symbol: NEIMX) is one of the few mutual funds that uses a conservative covered call strategy. We feel the net effect is the potential for reduction of risk with our portfolio. The type of risk being referred to is the type measured by a fund’s up and down NAV price volatility.
This covered call strategy is often used by conservative private investors, but it is not as commonly seen among mutual fund portfolio managers, who tend use a traditional buy and hold strategy. It is true that during raging bull markets, those using a covered call strategy might miss some of the upside gains enjoyed by many stocks in their portfolios. During bull markets, stocks with covered calls may increase in price well above the selected strike prices where stocks are targeted to be sold. During down markets, however, there are many instances where using a conservative covered call program has reduced losses, as compared to those using a traditional buy and hold strategy lacking covered calls.
How Calls Work
The basic concept of our conservative covered call strategy is as follows:
In this strategy, our portfolio manager gives the right to outside persons or entities to buy some or all of the stocks in the portfolio at a stated agreed upon price – usually a targeted price higher than what was paid for the stock. The person or entity who wants that right will pay us cash, called a premium, to hold that right open for a stated period of time. If the stock reaches the agreed upon price, usually referred to as the strike price, or even goes higher, during the stated period of time, the stock gets sold for the agreed upon price. If the stock does not reach the agreed upon strike price, the stock does not get sold and remains in our portfolio. In either case, our Fund keeps the cash premium received for granting the right to others.
Simple Covered Call Example
As an example:
A portfolio manager buys a stock for $50 a share, and then gives someone the right to buy that stock at $55 a share (strike price) during the coming three months. The portfolio manager will have received cash, for example $3 a share, for granting that right to purchase at $55. If the stock is higher than $55 at the end of the three months, it will be sold (“called” away) at the agreed upon strike price of $55 a share. The sale price is $55, whether the market price of the stock is $55 or higher. The total profit earned for the fund by the portfolio manager is the $5 gain + the $3 cash premium, or a total of $8 a share. Even if the stock soared to $100 a share, the fund is limited to a profit of $8 a share under this example.
Alternatively, still using this example, if the stock price remained below $55 at the end of the three months, the stock would not get sold. Our fund would still own the shares, which may be worth even less than the original $50 a share, but we would have the benefit of keeping the $3 a share we received as premium when we granted the covered call. Thus, our fund still earned an additional $3 a share, even if the stock price went down.
The potential benefit:
This strategy is most beneficial in sideways and even downside markets. It is a method of earning additional cash in the portfolio during times that are not strong bull markets. Our portfolio managers have also found that the amounts we receive as cash premiums for the covered calls helps lower the implied cost of stocks we purchase. Our Fund thereby earns cash revenue, almost like receiving an extra dividend. Those portfolio managers who use strictly a buy and hold strategy, without a covered call program, do not generate these additional cash premiums for their shareholders.
The term “covered” means that this strategy is used only on stocks owned in the portfolio. It is conservative, because it has the potential of reducing losses on the downside. In the same example of a stock purchased for $50 a share, and then receiving a cash premium of $3 a share for the covered call, it could be said that the stock only cost $47. In the event the stock goes down in price, for example, if it goes down to $45 a share, the stock would have lost only $2 a share in our example, not the full loss of $5 a share suffered in the traditional buy and hold portfolio. The $3 a share received as cash premium for the covered call helped reduce the full impact of the loss in price.
The portfolio managers of Neiman Large Cap Value Fund believe that by using this conservative covered call strategy, it has contributed to reducing a portion of the risk of our fund, as measured by price volatility, in comparison to other funds in our category who do not use such a strategy.