Did you know that you could earn monthly dividends on stocks at a rate that starts at 11.3% and could potentially go up to a staggering 94.9%? It sounds like a dream come true, doesn’t it? Well, that’s what some ETFs, that are generating eye-popping yields just by selling options contracts, are pitching to investors. But, this isn’t everything, as these ETFs, known as covered call ETFs, can also potentially shield you from a stock market crash.
Now, before you go looking for covered call ETFs, you need to understand that these ETFs are not some kind of magical money-making machines, even if they sound like it, and they can’t actually make all risk disappear. They also receive tons of criticism, which is why we’re going to clear up the confusion surrounding these controversial ETFs.
How Does a Covered Call ETF Work?
An option is a financial contract that gives its holder the right, but not the obligation, to buy or sell a specific asset, or a stock in our case, but a call option is a type of option that gives its holder the right, but not the obligation, to buy a stock at a set price called the strike price. When a call option is “in the money”, it can be exercised to buy the stock below its market price.
On the other hand, A covered call means selling a call option on a stock that you own, which gives you income in the form of a premium you receive for selling the call option. In a covered call ETF, option premiums are usually distributed to the ETF’s shareholders, and this creates the appearance of extremely high income yields. If you think this sounds good, then you might be surprised to know that covered call ETFs get criticized and so much backlash for this exact same reason.
The Criticism
The high income covered call ETFs generate isn’t actually an investment return, when you consider total returns. In fact, you’d probably get a higher total return by just owning a stock in a company, rather than the covered call version of that stock. This is because a covered call ETF has a 100% chance to underperform its underlying asset, so the stock specified in the call option, in the long-term, and there are two main reasons why this is the case.
The High Covered Call ETF Fees
The first one is that a covered call ETF has really high fees, and these fees are usually much higher than the fees associated with buying a stock. For example, if you buy Tesla’s (NASDAQ: TSLA) TSLA stock, you’d just be paying the stock price, so there’s no extra fees. On the other hand, if you buy YieldMax’s TSLA Option Income Strategy ETF (NYSEARCA: TSLY), which is a covered call ETF that focuses on TSLA stock, you’d have to pay a high annual expense ratio of 0.99%.
If you compare that with other ETFs that have 0.1% expense ratios, or even less, it’s like a 890% increase in fees, but this can be justified because a covered call ETF is harder to manage, since it requires active management by the fund manager, who has to write those calls, whether they’re monthly calls or weekly calls, and also decide the strike prices. Even though the high fees are due to the increased manual management, they still put this type of ETFs in the bottom of the market as people choose other ETFs with lower expense ratios.
How the Market Acts
As for the second reason why covered call ETFs don’t outperform their stocks in the long-term, we have the market behavior itself. The stock market tends, over the long-term, to go more up than down. This is actually harmful to covered call ETFs, because these ETFs work with a covered call strategy, and that’s basically sacrificing any upside the stock gains, in order to profit off the option premiums.
In other words, covered call ETFs are funds that promise not to beat the stock market, meaning that there’s absolutely no chance that a covered call ETF will outperform its underlying security in the long-term. As for the short-term and medium-term, it’s certainly possible for these ETFs to outperform the market, but only if the market is flat or in a downwards trend, because selling covered calls limits the upside potential. Therefore, these ETFs are criticized for a variety of reasons, but they all could be summed up into the fact that they don’t generate the same total return as their underlying stocks.
Why Do People Invest in Them?
If covered call ETFs were so bad, they wouldn’t attract so many investors, and they might actually be misunderstood by so many people. For starters, you should know that covered call ETFs aren’t designed for generating maximum total returns or for investors who are seeking long-term growth, but for income generation while lowering volatility at the same time, and they’re only good for income-oriented investors.
In that sense, they’re similar to investments like government bonds or guaranteed investment certificates. You don’t buy those for maximum total return or to beat the stock market, right? No, you buy them for more safety and consistent income. Since the main risk when investing in stocks is basically the market underperforming and the stocks trading in a downwards trend, writing covered calls allows you to generate premiums to cushion the downside in the stock market.
As mentioned above, a covered call ETF performs better when the market is in a downtrend, and that is one of the reasons why people buy these ETFs in case the market fails. In other words, owning shares in a covered call ETF is just a defensive way of owning whatever the underlying stock is.
Who Should Invest
If your number one priority is achieving total return, meaning that you don’t care about receiving income right now, and just want to maximize your total return, or put in some money and let it grow for, say, ten years, then you probably shouldn’t buy a covered call ETF. Of course, you can still buy it if you want a bit less risk during that ten years, meaning that if you have $10,000 to invest, you can split it between an S&P 500 ETF to maximize your returns over the years, and a covered call ETF to hedge against the market downtrends during that same period.
You can also buy them tactically as a trader, meaning that if you think that the stock market could go down or be flat in the future, you could invest in a covered call ETF that tracks NASDAQ or the S&P 500. In addition to that, you can invest in them if you’re looking for a tax-efficient investment, because covered call ETFs generate income through the sale of call options rather than through dividend payments, they may be more tax efficient than other types of income-generating investments.
The Risks
Selling call options also comes with its own set of risks. If the price of the underlying stock increases significantly, the ETF may have to sell the stock at the strike price, which could result in a loss. There’s also the counterparty risk, meaning that when an ETF sells a call option, it’s entering into a contract with the buyer of that option, and if the buyer is unable to fulfill their end of the contract, the investor may be left with a loss.
Examples of Covered Call ETFs
Now that you know exactly what you’re getting into, here are three examples of covered call ETFs that you can invest in.
QYLD Covered Call ETF
For the first covered call ETF, we have the Global X NASDAQ-100 Covered Call ETF (NASDAQ: QYLD). The NASDAQ-100 has seen strong bullish momentum throughout 2023, but it’s also extremely volatile. But, you can capitalize on the ups and downs of the NASDAQ-100 by investing in a covered call ETF that tracks it, and that’s what QYLD is for.
QYLD sells monthly at-the-money covered calls, which means that the strike price of an option is equal to the stock’s current market price, on 100% of its portfolio. Currently, QYLD pays a very high 11.53% yield, and charges a 0.61% expense ratio. It also trades at around $18, and its largest holdings are Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), and Amazon (NASDAQ: AMZN).
DIVO Covered Call ETF
There’s also the Amplify CWP Enhanced Dividend Income ETF (NYSEARCA: DIVO). If you’re an investor searching for an actively managed covered call ETF with a small, high-conviction portfolio, you may like DIVO. This ETF selects a portfolio of large-cap U.S. stocks which show above-average dividend growth and high financial quality.
To increase income, DIVO sells covered calls on individual stocks, with strike prices and expiry dates left up to the discretion of the portfolio management team. So far, this approach has worked well, as DIVO achieved a 5-star Morningstar rating among its peers, meaning that it has outperformed the vast majority of rival funds on a risk-adjusted basis. Still, DIVO pays a fairly low yield for a covered call ETF at 4.57%, but it makes up for it with a low expense ratio of 0.55%, which is close to the average ETF expense ratio at 0.49%.
It trades at around $37, and its largest holdings include Microsoft, Visa (NYSE: V), and UnitedHealth Group (NYSE: UNH).
JEPI Covered Call ETF
There’s also the JPMorgan Equity Premium Income ETF (NYSEARCA: JEPI). This ETF is one of the most popular covered call ETFs on the market, as it has attracted just over $30 billion in assets under management since its debut in May 2020.
JEPI’s stock selection is not based on an external index benchmark. Instead, the ETF’s management team actively chooses stocks that they believe will deliver the bulk of the S&P 500’s returns, but with lower volatility. Since JEPI actively picks its stocks, it doesn’t have exposure to the entire S&P 500 necessary for directly selling covered calls. Instead, the ETF buys equity-linked notes from a counterparty, which provides a sort of artificial exposure to a covered call strategy.
JEPI charges a very low expense ratio of 0.35%, and pays a yield of 7.96%. It trades at around $56, and its largest holdings include Amazon, Microsoft, and Intuit (NASDAQ: INTU).
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