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David Merkel has post about chasing yield offered by investment products, specifically closed end funds, that is a must read. The tipping point for the article was an article from the Wall Street Journal that ran on Friday.

Both articles offer a little bit of caution and skepticism to consider for anyone considering a call writing fund, a dividend capture fund or a fund that does both.

I have written about these types of funds many times and even been quoted in a couple of places on this subject.

The notion that a glut of these funds could have an adverse impact on the markets they invest in or that something could go wrong internally, think large scale problem, is not that high, in my opinion, but is absolutely within the realm of possibility.

If you are going to use these types of funds you have to mitigate this issue for yourself. I think the easiest way to do this is to use these funds in moderation. I have disclosed many times that for clients who are a little more tolerant of volatility I weight the one call writing fund I use at 10% of the fixed income portfolio which works out to at most 4% of the overall account (think here about an account with 40% allocated to fixed income). For clients with a little less tolerance for volatility I think of these as being part of the equity portion and weight it at about 3% of that part of the portfolio.

I don't believe that any of the other fixed income segments would be truly damaged if something bad happened in the call writing segment. If the fund I use somehow blows up in a manner I cannot foresee the consequence would be a small lag which I think is acceptable. It would be unacceptable to me to have four different funds totaling 10% of the account when a blow up happens potentially causing some sympathy declines in other funds.

Part of the understanding here, and this is very simple to grab onto, is that if treasuries yield somewhere near 4.75%, there is risk in anything that yields more than treasuries (obviously you need to consider like maturities).

There is not a whole lot of recklessness in having exposure to investment grade corporate debt in the high fives or low sixes but a portfolio full of products that yield 8-9% in a 4.75% world is not a risk I would take for anyone.

A conservative way to look at this might be simply seek to add a few basis points to the overall mix. A $500,000 account allocated 70/30 with $15,000 (out of a possible $150,000 earmarked for fixed income) in a call writing fund will add some basis points overall without jeopardizing your financial future if you own the one fund that blows up.

Still this is not for everyone, that needs to be decided on first of course. I do view these funds as very useful but to repeat myself where these funds are concerned; moderation, moderation, moderation.

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