Covered call exchange-traded funds, which offer attractive yields that can reach 10% or more, have become a popular investment. The product essentially invests in stocks and sells call options on all or part of the portfolio. The result is income for investors based on the option premium in exchange for a capped upside if the option is exercised. “The dividend is not free,” said Morningstar Managing Research Analyst Lan Anh Tran. “The dividend comes at the expense of upside.” This can be costly, especially when the market is rising. The fund should outperform when the market is flat or falling, investors receive a premium and the stocks are not called. That’s exactly what happened in 2022, when the S&P 500 fell nearly 13%, Tran said. “Obviously, in a market like 2023, or even the first half of 2024, when the whole stock market is rising, these funds will lag the market,” he said. The S&P 500 is up 18% so far this year, while the Nasdaq Composite is up 23%. Still, ETFs remain popular. Morningstar’s Derivatives Income category, which is dominated by covered call ETFs, saw $24.3 billion in inflows over the past year as of June. Total assets under management now stand at $90.6 billion. The largest actively managed covered call ETF is the JPMorgan Equity Premium Income ETF, which has a 30-day yield of 6.88% and an adjusted expense ratio of 0.35%. It’s up 6.64% year-to-date. JEPI has seen nearly $4.9 billion in inflows over the past year, according to FactSet. Assets under management now stand at about $34 billion. JEPI 1Y Mountain JEPI 1Y Performance Global X also has a series of passively managed funds that track various indexes. For example, the Global X Nasdaq 100 Covered Call ETF (QYLD) has more than $8 billion in assets and is up 3.5% year-to-date. The S&P 500 Covered Call ETF (XYLD), with nearly $3 billion in assets, is up nearly 4%. Global X sells index call options on the third Friday of every month, said Rohan Reddy, the firm’s director of research. Sometimes it’s 50% of the portfolio, sometimes it’s the entire portfolio. Annual distribution yields can reach double digits. As of Thursday, QYLD was yielding 11.09% and XYLD was yielding 7.97%. Both have total expense ratios of about 0.6%. Both ETFs have seen inflows this year, but inflows have slowed as the market has risen, Reddy said. QYLD has seen inflows of about $154 million over the past year, while XYLD has seen inflows of $40 million in the same period, according to FactSet. QYLD 1Y Mountain Global X Nasdaq 100 Covered Call ETF 1-Year Performance “Certainly, in an environment like this where volatility is low and the market is rising, [it’s] “It’s probably not the most ideal time” for these funds, Reddy said. “That said, most of the investors who are evaluating our funds or who continue to invest in them are prioritizing income over anything else.” RFG Advisory President and Chief Investment Officer Rick Wedel said investors should also keep in mind that markets may become more volatile as the presidential election approaches. While Wedel doesn’t recommend timing the market, buying and holding covered call ETFs could be a strategy for clients looking for ideas to take advantage of a potential downturn ahead. “This doesn’t protect you 100% from losses,” he said. “But this is a way to put a little bit of a cap on the upside and instead outperform when the market starts to fall a little bit.” What investors should look out for Wedel advised that whether the ETF is an index-based fund or a stock portfolio, investors should first understand the underlying securities within the ETF. “Do you want exposure to large caps? Do you want exposure to small caps? Do you want exposure to international stocks?” he said. “All of those things are important to consider.” Investors should also pay attention to the strategy the fund manager is using, which affects the upside potential and the call premium. Deep in-the-money or at-the-money calls will have higher premiums, but you may be giving up most of the capital appreciation potential, Global X’s Reddy explained. Out-of-the-money calls will have lower dividend yields but may have more upside potential, he explained. The most popular funds sell at-the-money and slightly out-of-the-money covered calls, he noted. Wedel doesn’t think going for the highest yield is necessarily the best option. “My favorite sweet spot money is to go with something that has a slightly lower dividend yield,” he said. “You’re less likely to be faced with the problem of, ‘Oh, what if the market goes up 35% and hits the ceiling?'” he added. “I like these stocks because they offer high dividend payouts to investors who care, but with low caps.” Plus, you have to consider fees, which can eat into your returns. “When you buy SPY stock, [SPDR S & P 500 ETF Trust] It’s a few basis points. “And with some of these more esoteric style strategies, you’re starting to talk about extreme expense ratios in the 60s or even higher,” Wedel said, referring to the number of basis points that funds charge. A basis point is equal to one-hundredth of a percentage point. “It’s very hard to generate a lot of alpha over the long term with that strategy to make up that gap,” Wedel noted. Those using covered call ETFs as a long-term strategy should pick funds with low enough expense ratios that the gap doesn’t exceed the returns, he advised. Additionally, keep in mind that funds can be structured in different ways, so it’s hard to compare yields like you would when looking at a standard fund. “Unfortunately, I don’t think there’s a really good single metric right now that gives you just one number across the board and lets you compare all the funds,” Morningstar’s Tran said. That has to do with how the funds are classified for tax purposes, he said. For example, JEPI is structured so that everything is paid out as interest income, which Tran said is usually taxed at the same rate as ordinary income. Other funds may be subject to capital gains tax, usually at a lower rate than ordinary income tax rates, Tran said. Tax treatment can be complicated, so experts recommend consulting a tax professional. Ultimately, investors need to consider whether they would be better off adding this strategy as part of their portfolio to generate income or sticking to a standard balanced portfolio of stocks and bonds, Tran said. She suggests looking at the track record to compare possible alternatives. For example, the Chicago Board Options Exchange has an index that tracks at-the-money call sales and another that tracks out-of-the-money call sales, she said. “Like any investment product, you need to understand what you’re giving up for something that sometimes seems too good to be true,” Tran said.
This strategy, although costly, can deliver double-digit returns.
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