Smoothing out returns during major market swings is a front-and-center issue for many investors who have been through the carnage of the past two months.

One approach used by institutional investors is so-called BuyWrite strategies. It's a method that allows fund managers to buy a basket of stocks and then write covered call options on the holdings.

During periods of flat or negative returns, BuyWrite funds tend to smooth volatility, while allowing investors to pick up some income from options premiums.

The trade-off is that in heady bull markets, such a tack can limit upside potential. In 2003, for example, when the S&P 500 was up 26%, the Chicago Board Options Exchange's CBOE S&P BuyWrite Index (BXM) gained 18%. (For an earlier overview of BuyWrite funds, see story here.)

Since such strategies rely on writing options contracts and generally appeal to conservative investing strategies, BuyWrite funds have remained outside the sweet spot of mainstream investors and financial advisors.

But some changes are taking place in the marketplace. Within the past few years, closed-end fund providers have started to break into the market, offering portfolios based on the strategy specifically for the average investor. Some offer active strategies that mix options trading with more aggressive strategies that appeal to a broader investment audience.

As a result, both in terms of numbers and assets, BuyWrite closed-end funds have garnered a growing acceptance in the retail marketplace. That has led two major ETF companies to try implementing such methodologies through exchange-traded funds.

First To Market 

Barclays was first to market with its iPath exchange-traded note in May 2007, the iPath CBOE S&P 500 BuyWrite Index ETN (AMEX: BWV). PowerShares followed in December 2007 with two BuyWrite ETFs, hedging exposure to the S&P 500 and NASDAQ 100 indexes-PowerShares NASDAQ-100 (NasdaqGM: PQBW) and S&P 500 BuyWrite (NYSEArca: PBP).

To date, iPath's BWV has only amassed some $21 million in assets, which is down slightly from the end of September. PowerShares' two BuyWrite ETFs have taken in twice that amount, approximately $52.5 million. (Roughly $50 million of those assets are in PBP.)

But one encouraging sign for PowerShares is that PBP took in approximately half of its assets in the month of August alone, which could suggest that a little traction has been gained for the approach. All together, though, the three still have less than $75 million in total assets.

Year-to-date, the SPDRs Trust (AMEX: SPY) was down 36.67%, while PBP had returned -26.65% and BWV -27.32%. In the past three months, SPY had dropped 28.48%, much more than PBP (-21.91%) and BWV (-22.51%), according to Morningstar market returns (as of 2:30 p.m. ET Friday, Oct. 24).

Advisors who use the BuyWrite strategy stress that the smoothing effects need to be measured over much longer periods of time to show their greatest benefit. "You can't figure out if the BXM index is going to be good or bad by looking at it after a week or two of the worst markets ever. You have to look at the entire bear market and stock market cycle," said Roger Nussbaum, portfolio manager at Phoenix-based Your Source Financial.

And long-term data would seem to support his view. From June 1986 through May 2008, the CBOE S&P BuyWrite Index had returned 10.7%. That exactly matched the performance of the S&P 500's return over that same period. A key, however, is that the BuyWrite benchmark achieved those returns with significantly less volatility, says the CBOE.

The BuyWrite strategy's major benefit is the premium generated from options writing. Both PBP and BWV reinvest the income from the options in the fund, increasing total return, as opposed to breaking out the income component as a separate income stream for investors.

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