Q:  What is the philosophy of Kelmoore Strategy® Eagle Fund?

A: The Fund's goal is to maximize realized gains from covered option writing; it's exclusively what we do. Our portfolio consists of leading equities mainly from the technology, financial, and biotechnology sectors. We invest in financially strong, profitable companies.

We look for stocks with higher levels of implied volatility than the market average. Implied volatility is the market's prediction for future movement in an equity. Expressed in percentage terms, it translates directly into option premium levels. For example, if an option trades at a “40 vol”, it means the market is anticipating the underlying equity to have a 40% move over the next 12 months, either upside or downside. That's a big move and it translates directly into option premiums.

Ideally we seek names with implied volatility of at least 24. We currently hold a portfolio of software, hardware, semiconductors, financial companies, biotechs, and a special category for names with higher implied volatility that don't fit in the other categories. For example, McDonald's may fit this category because the options trade near their high implied volatility right now.

Our strategy is to buy the stock, write calls against it, and distribute the realized gains to investors on a monthly basis. Although total return is important, we market this fund as a cash flow alternative. Our 12 month yield is 12.6%. We try to have an A-rated equity portfolio with a junk-bond type of yield. We use equities instead of debt instruments to create this type of yield.

Today the fund owns about 25 stocks and has $250 million in assets. Strong fundamentals are important in stock picking, but we also want to take good entry points. We look for upside when picking a stock that competitors reject, or a stock we hope can go higher. We may actually do well owning stocks with high levels of implied volatility that do nothing. We pay distributions to our investors and I write another set of calls for the next month(s).

Q:  So you have a short-term exposure of about a month?

A: A month on the option side. We are almost exclusively selling near expiration options because you get the greatest yields.

Q:  What is the best case scenario for your approach? Is it if the underlying stock doesn't do anything because then you collect the entire premium yourself?

A: In this environment option premiums are about as low as they've been in 10 years. We are just now moving up from a 10-year low for implied volatility. There are pluses and minuses to that environment. In higher-volatility environments you earn more for options and we tend to sell options at 3% to 5% even 7% out-of-the-money each month, which means the underlying equity could move up by that amount.

The ultimate scenario for our portfolio is actually a very mild rise in the markets. With a 1% rise per month in the equity market, we'd see a rise in the portfolio and we'd earn the money from the options expiring, but that's a best case scenario in terms of total performance. In terms of outperformance in a market that does nothing, when we are able to get option premiums of 12% a year, or 1% a month, then we might outperform by 12%.

Q:  Why have you chosen this type of investment philosophy? What are the inherent benefits of writing covered calls and using the cash flow for distributions?

A: We've had investors who invest only in short-term GE paper, for example, which pays very little but is not risky. What we do is own the stock and write a call against it. Owning the same company and using the equity we may be able to earn 0.75% a month, in the case of GE. We are also entitled to any dividend, so we'd get the dividend yield in addition to the option premiums.

It's a different philosophy. We use equities instead of debt instruments and that provides us with a risk/reward ratio that may be favorable for the investor. If you want to invest in the debt instrument, you are probably willing to invest in the equity with written options on it. Of course, entry points are crucial, but you may be rewarded with our investment style to a greater extent than in the debt market.

Q:  You mentioned that you have about 25 names in the fund. How big is the universe that you draw from?

A: I scan the Nasdaq 100 daily. The universe consists of probably no more than 150 stocks. The S&P 100 and the Nasdaq 100 are essentially where I look for candidates.

Q:  Various sectors have various volatility and bond yields change as well. Do you consider macro themes and their implications on volatility?

A: We believe in market cycles. There are similarities between what we are experiencing now and 1994, which is low volatility and relatively low interest rates expected to increase. Low rates bring speculation on smaller-cap companies because it is cheap to borrow money. As rates rise, we focus on largecap companies with healthy balance sheets because the cost of borrowing rises and large caps tend to need to borrow money less. In this stage of the cycle, investors turn to large-caps, not because they offer greater appreciation potential, but for the safety factor. Small and mid-caps tend to do well at the beginning stages of a recovery, while at later stages, larger-caps tend to excel.

Finally large caps, even in the tech sector, are trading at all-time low multiples. Oracle and Intel are trading at a discount not to their sector, but to the market as a whole. Some of yesterday's big winners are now value plays. Valuation may represent a safety net although you are not rewarded as much on the implied volatility side. That is the trade off - there aren't tremendous option premiums, but these stocks provide some protection because of their low valuation and the expectations for future valuation.