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.

Bruce Bond, chief executive at PowerShares, says that the original research leading up to the launch led the company to believe that it was best to use the premiums to enhance total return. Furthermore, when PowerShares originally looked at the closed-end offerings, it took into account that closed-end funds pay out income because it is a dividend method that helps the funds to support their share price.

That is a market-specific issue for closed-end funds, which have historically moved between wide premiums and discounts, that ETFs don't ordinarily need to consider. It seemed the best option for investors was to invest the income as part of total return enhancement, Bond says.

Now, however, some advisors are stepping forward and telling PowerShares that they would prefer a separate income component. Bond says that ultimately, it is a question of whether advisors and investors want to use PBP first and foremost as an income play or to create a lower correlation asset in the portfolio with a good total return profile.

"We might just have two different camps at end of the day and that's why we need to do more investigation," he said.

From Nussbaum's perspective, one advisor can find himself a member of both camps: "I prefer there to be an income stream on the fund, but the smoother ride is more important to me than the dividend issue. That said, if there were a version of the fund with an income stream, I might switch clients who are older than 50 into that portfolio."

Philippe El-Asmar, head of investor solutions at Barclays Capital, noted that Barclays does have other ETNs that pay income, and that most closed-end BuyWrite funds regularly pay income.

"It may very well be the income aspect, and going forward, there is room for both approaches," El-Asmar said.

The Real Differentiator? 

However, El-Asmar is not yet convinced that the income issue is the real differentiator between the ETFs' lack of success and the closed-end fund asset juggernaut that has seen a relatively large number of assets go into funds with such strategies.

An important distinction between the closed-end fund market and the ETF market is the broker-sold nature of closed-end funds. It may turn out that the lack of success for the BuyWrite strategy in the ETF format has less to do with structure, and more to do with the traditional wire house strength in selling closed-end funds, says El-Asmar.

"Right now, we do see more success in the closed-end funds linked to the BuyWrite strategy, but is it more because of the income structure, or are those closed-end funds more successful because they are sold with a commission by brokers to private clients?" he said.

If it is the latter, and there is no structural fix providing an income stream that can help the BuyWrite ETFs, it may be a longer battle for BuyWrite ETFs to gain acceptance, and assets. "One would expect that investors would like the BuyWrite strategy better without a 3% or 4% commission, but that hasn't happened yet. Maybe it's a matter of education and time," El-Asmar added.

Compounding the problem for Barclays, however, may be the much tougher education and marketing effort now required for the exchange-traded note market, regardless of the specific investment strategy.

ETNs have been abandoned by many investors in the wake of the credit crisis and fears about the unsecured debt nature of the products.

In September, the ETN market had net outflows, and Barclays, in particular, suffered the most as the largest ETN provider (see story here.)

"ETF is the preferable wrapper. It doesn't matter if there is or if there isn't a chance that Barclays goes out of business. In terms of worrying about clients' money, I don't need to think about which to use, and it's PBP," Nussbaum said.