An entire investment sub-industry has sprung up around covered call ETFs. They have boomed in popularity in recent years, with assets under management growing from about $18 billion in early 2022 to roughly $80 billion as of July, according to Morningstar data.
Inflows into these ETFs have been driven by the prospect of stock-like price gains combined with bond-style income and low volatility. JPMorgan’s popular Equity Premium Income ETF (JEPI), the largest actively managed ETF in the U.S., says the fund’s aim is to provide “a significant portion of the returns associated with the S&P 500 index with less volatility,” according to its marketing material.
There are even entire investment newsletters devoted to the subject. That very fact has me wondering whether they are a good place for the average investor to put some of their money. First though, let’s cover the basics of covered calls and covered call ETFs.
Covered Calls
It all starts simply - a covered call is where you write (sell) an option for an underlying stock that you own. When you sell the option, you collect the premium from the option buyer, but are at risk of being forced to sell your stock.
When the expiration date hits, two things could happen:
- If the stock price is below the strike price, the option expires out of the money, and as an options writer, you no longer have any obligation to sell the stock and can pocket the cash from the option premium you sold.
- But if the stock price is above the strike price, the option expires in the money and your stock will be called away by the buyer.
In effect, this strategy limits your potential upside from holding a stock. But it provides a guaranteed income in the form of the option premium. You’ll also still have the downside risk from holding the stock.
Nevertheless, the idea of additional income is very appealing, and so many investors turn to ETFs that use this strategy.
Covered Call ETFs
A covered call ETF is an exchange-traded fund (ETF) that holds stocks and also writes call options against these stocks. Other names applied to this type of ETF include “buy-write,” “option income,” and “premium income.”
Like traditional ETFs, these funds provide exposure to the stock market via an index, such as the S&P 500 Index ($SPX). What makes them different is that they also write (sell) call options on their underlying portfolios. Most write options that expire monthly, but a few write options that expire each day.
The pay-off of a covered call ETF is roughly the same as for the covered call strategy discussed above. The difference is that you pay fees to the fund manager to execute the strategy. The fees are higher than for a standard index ETF and eat into your return.
The main advantage of covered call ETF is that it’s all done for you. You don’t have to pick expiration dates and strike prices or spend time selling new options after the previous ones expired. Also, these ETFs could also increase the diversification of your portfolio.
Now, let’s look at their performance and whether they’re a good idea for the typical investor.
Not-So-Hot Performance
From time to time, the market reminds investors that there's no such thing as a free lunch, and strategies that appear to serve up tasty returns turn out to be not so tasty.
In general, covered-call ETFs have performed well in flat to moderately bullish markets.
However, when markets rise quickly, covered call ETFs typically underperform traditional, long-only ETFs that haven't sold options. That's because it's likely that the call options they've sold will be exercised, and the stocks will either be "called away" (delivered to the buyer of the call contract), or the fund will close its position by buying back the call option at a loss.
On the other hand, when the market drops a lot - as it did recently - covered call ETFs offer little protection from the downside. The relatively small income generated by selling options is not enough to offset the decline in the underlying shares. In fact, covered call ETFs end up underperforming the index.
Just look at the performances so far in 2024. Year-to-date, the S&P 500 Index is still up 14.5%. But the Cboe’s S&P 500 Buywrite Index ($BXM) is lagging, up only 10.6%. And JEPI is up just under 6%.
Popular covered call funds tied to the Nasdaq-100 Index ($IUXX) have also underperformed. The Nasdaq-100 is up 10.6% year-to-date. Meanwhile, the Global X Nasdaq-100 Covered Call ETF (QYLD) is up less than 1% year-to-date.
Look Elsewhere for Income
Why the difference?
While covered call ETFs use what is called an “income strategy,” in reality, these ETFs are just selling volatility. That can work great for long periods of time, but can get hammered when the market tanks and volatility spikes.
In other words, covered call ETFs do NOT like volatility.
That’s why I maintain that, for a long-term investor, it’s not a buy-and-hold investment. You’re giving up a lot of upside, and compounded over the long term, that’s not smart.
I’d rather stick with dividend-paying stocks, or ETFs focused on such stocks, for the long-term.
On the date of publication, Tony Daltorio did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
