Back in January, I wrote a cautious article on the Nuveen S&P 500 Dynamic Overwrite Fund (NYSE:SPXX), noting that in general, call-overwrite funds trade off upside for premium income so they tend to lag markets over the long-run. As a total-return focused investor, I lean towards avoiding call-overwrite funds.
Since my article, the SPXX fund has delivered -0.8% in total return, which seems to justify my caution (Figure 1).
Figure 1 – SPXX’s stock price has performed poorly in 2023 (Seeking Alpha)
However, I believe the SPXX fund has been unfairly punished by investors, as the actual performance of the fund has been decent. YTD to November 30, 2023, the SPXX fund had actually returned 15.1% on a NAV basis, significantly better than the fund’s market price performance (Figure 2).
Figure 2 – SPXX has delivered solid returns, but its stock has sold off (morningstar.com)
The unwarranted sell-off in SPXX units now present an interesting opportunity, as the SPXX fund is trading at a steep 8.7% discount to NAV, near the widest in the past 5 years (Figure 3).
Figure 3 – SPXX trading at an 8.7% discount to NAV (cefconnect.com)
Whereas the SPXX fund was trading too rich relative to its NAV in late 2022, I believe the SPXX fund is now trading too cheaply and presents investors with a buying opportunity.
Brief Fund Overview
First, for those unfamiliar with the SPXX fund, the Nuveen S&P 500 Dynamic Overwrite Fund is a closed-end fund (“CEF”) that holds an equity portfolio tracking the S&P 500 Index while dynamically selling call options (“call-overwrite”) to generate income.
The SPXX fund employs a ‘dynamic overwrite’ options strategy that sells call options covering a varying percentage of the fund’s equity portfolio, depending on the manager’s outlook. Under normal market conditions, the SPXX fund aims to sell call options on 35-75% (55% long-term target) of the notional value of the fund’s equity portfolio. This allows investors in the fund to capture upside from the fund’s equity exposure while supplementing the portfolio’s income with call premium income.
Due to tax considerations, the SPXX fund does not fully replicate the holdings of the S&P 500 Index. However, it does hold a portfolio that more or less match the overall characteristics of the index. Currently, the SPXX fund holds 485 positions with sector weights shown in Figure 4.
Figure 4 – SPXX fund characteristics (nuveen.com)
SPXX’s sector weights are broadly similar to that of the market, as represented by the SPDR S&P 500 ETF Trust (SPY) (Figure 5). Relative to SPY, SPXX has a slight underweight in Information Technology and Industrials, and a slight overweight in Financials and Health Care.
Figure 5 – SPY sector allocation (ssga.com)
Furthermore, we can see that as of October 31, 2023, the SPXX fund had overwritten 48% of the portfolio with calls struck at 104% of spot price (Figure 6) using mostly monthly options (i.e. weighted average option expiry < 18 days). This is pretty standard for a call-overwriting fund.
Figure 6 – SPXX option portfolio overview (nuveen.com)
Modest Long-Term Returns…
The hallmark of call-overwriting funds are long-term returns that trail the markets, as call-overwriting strategies give up a portion of its portfolio upside in exchange for a steady stream of option premium income (Figure 7).
Figure 7 – Illustrative S&P 500 Index monthly returns (Author created with data from Yahoo Finance)
This has caused the SPXX fund to deliver modest 3/5/10/15 Yr average annual NAV returns of 7.3%/7.2%/7.2%/9.0% respectively to November 30, 2023 (from Figure 2 above).
In contrast, the SPY ETF has returned 9.7%/12.4%/11.7%/13.6% on the same timeframes (Figure 8).
Figure 8 – SPY historical returns (morningstar.com)
… Sufficient To Fund Attractive Distribution Yield
However, readers should note that SPXX’s long-term average annual returns of 7.2% over 10 years is sufficient to fund its attractive distribution yield, currently set at $0.294 / quarter or a forward yield of 8.0% on market price and 7.3% on NAV (Figure 9).
Figure 9 – SPXX pays an 8% forward yield (Seeking Alpha)
The SPXX fund is yielding more than 5x the S&P 500 Index, which is yielding just 1.4%.
Discount To NAV Presents A Buying Opportunity
Normally, I would recommend investors steer clear of the SPXX fund, since its call-overwriting strategy leads to long-term underperformance. However, occasionally, market dislocations can allow investors opportunities to buy decent assets on the cheap. I believe we currently have such an opportunity with the SPXX fund.
Recall from Figure 3 above, the SPXX fund is currently trading at an 8.7% discount to NAV. Since the SPXX fund only holds large-cap stocks and written call options, its NAV is fairly straightforward and easy to monitor.
On a YTD basis, the SPXX fund has actually performed well, returning 15.1% on a NAV basis to November 30, 2023, compared to 20.7% for the SPY ETF or 73% upside capture. Since SPXX typically overwrites ~55% of its portfolio but was able to capture ~70% upside, that is a fairly attractive risk-adjusted return.
Risks To SPXX
Of course, one of the downsides of call-overwrite strategies is that while it trades off upside for premium income, most of the downside is retained by the fund. So if the markets were to decline significantly in the coming months, the SPXX fund will have very high downside capture.
For example, in 2022, when the SPY ETF declined by 18.1%, the SPXX fund lost 14.7% on a NAV basis, or 81% downside capture (Figure 10).
Figure 10 – SPXX lost 14.7% in 2022 or 82% downside capture (morningstar.com)
Conclusion
Normally, I would not recommend call-overwrite strategies as they tend to underperform over the long-run. However, with the SPXX fund trading at an 8.7% discount to NAV, I believe its shares may provide an attractive buying opportunity for income-oriented investors, assuming its discount to NAV will close in the coming quarters.
Read the full article here