This strategy can offer double-digit yields — at a cost

Published Fri, Jul 12 20243:01 PM EDTUpdated Fri, Jul 12 20245:36 PM EDT

With tantalizing yields that can reach 10% or more, covered-call exchange-traded funds have become a popular investment. The products essentially invest in stocks and then sell call options on all or a portion of the portfolio. The result is income for investors, based on the option's premium, in return for capped upside if the option is exercised. "That payout is not for free," said Morningstar manager research analyst Lan Anh Tran. "The payout was coming at the cost of your upside." That can be particularly costly during a market rally. The funds should outperform when the market is flat or down, and investors collect the premium and the stocks don't get called away. That's what happened in 2022, when the S & P 500 lost nearly 13%, Tran said. "Obviously, in a market like 2023, or like the first half of 2024, when the … broader stock market has just been going up, these are going to lag the market," she said. The S & P 500 has gained 18% so far this year, while the Nasdaq Composite has rallied 23%. Still, the ETFs remain popular. The derivative income Morningstar category, dominated by covered-call ETFs, saw inflows of $24.3 billion 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 6.88% 30-day yield and an adjusted expense ratio of 0.35%. It is up 6.64% year to date. JEPI has seen nearly $4.9 billion in inflows over the past year, according to FactSet. Its assets under management now stand at about $34 billion. JEPI 1Y mountain JEPI's one-year performance Global X also has a series of passively managed funds that track various indexes. For instance, the Global X Nasdaq-100 Covered Call ETF (QYLD) has more than $8 billion in assets and is up 3.5% year to date. Its S & P 500 Covered Call ETF (XYLD) has nearly $3 billion in assets and is ahead nearly 4%. Global X writes index call options on the third Friday of every month, said Rohan Reddy, the firm's director of research. In some cases, it's on 50% of the portfolio, in other cases it is on the entire portfolio. The annual distribution yield can reach double digits. QYLD's yield is currently 11.09%, while XYLD's is 7.97%, as of Thursday. Both have total expense ratios around 0.6%. Both ETFs have seen inflows this year, although they have slowed as the market has moved higher, Reddy said. QYLD has seen about $154 million in inflows over the past year, while XYLD had $40 million over that time, according to FactSet. QYLD 1Y mountain Global X Nasdaq 100 Covered Call ETF one-year performance "Admittedly, an environment like this, where volatility is low and markets are moving higher, [it's] probably not the most ideal" time for these funds, Reddy said. "That being said, most of the investors who are either evaluating our funds or continuing to remain in our funds, they prioritize more of the income as opposed to anything else." Another thing to bear in mind is that the market may become more volatile as the presidential election nears, said Rick Wedell, president and chief investment officer at RFG Advisory. While he doesn't recommend trying to time the market, buying and holding covered-call ETFs could be a strategy for a client asking for ideas to take advantage of a potential downturn ahead. "It's not going to shield you from 100% of your losses," he said. "But it is a way to say, let's … maybe put a little bit of a cap on our upside but in exchange we will outperform if the market starts to slip a little bit." What investors should look for Investors should first understand the underlying securities within the ETF, whether it is an index-based fund or a portfolio of stocks, Wedell advised. "Do I want large-cap exposure? Do I want small-cap exposure? Do I want international exposure?" he said. "All of that type of stuff is important to consider." Investors should also be aware of the strategy being used by the fund managers, which will affect the upside potential and call premium. Deep-in-the-money or at-the-money calls will result in higher premiums but you may give up most of the capital appreciation potential, Global X's Reddy explained. XYLD 1Y mountain Global X S & P 500 Covered Call ETF's one-year performance Out-of-the-money calls deliver a lower dividend yield but you may retain more upside, he explained. The most popular funds are writing at-the-money and slightly out-of-the-money covered calls, he noted. Wedell doesn't think going for the highest yield is necessarily the best option. "My favorite sweet spot of the money is to use things that maybe have a little bit lower dividend yield," he said. "We run into less of that problem around like, 'Oh, shoot, what happens if the market runs by 35% and I'm capped,'" he added. "I like those because you're still getting a nice high dividend payout for the investors that care about that, but you're getting less of an upside cap." Then there are the fees to consider, which can also eat away at returns. "You can buy the SPY [SPDR S & P 500 ETF Trust] for a couple of basis points. And for some of these more esoteric style strategies, you're starting to talk about extreme expense ratios that are in the 60s, maybe even higher," Wedell said, referring to the number of basis points a fund charges. One basis point equals one-hundredth of a percentage point. "It's real hard over time to generate a lot of alpha within that strategy to be able to make up that gap," Wedell noted. Those using covered-call ETFs as a long-term strategy should choose funds that have a low enough expense ratio where the gap doesn't override the return, he advised. In addition, keep in mind that because funds can be constructed differently, it is hard to compare yields as might be done when looking at standard funds. "I don't think currently there's really a good one single metric, unfortunately, to be able to kind of holistically just have one number and compare across all the funds," said Morningstar's Tran. It has to do with how the funds are classified for tax purposes, she said. For instance, JEPI is structured so that everything is paid out as interest income, which is typically taxed at the same rate as ordinary income. Other funds may be subject to capital gains taxes, usually lower than ordinary income tax rates, she said. Since the tax treatment can be tricky, experts suggest consulting a tax professional. In the end, investors should consider if they want to add the strategy as part of their overall portfolio to bring in some income, or if they are better off sticking to their standard balanced portfolio of equities and fixed income, Tran said. She suggests looking at track records to compare possible alternatives. For instance, the Cboe has an index that tracks selling at-the-money calls , as well as one that tracks selling out-of-the-money calls , she said. "As with any other investment product, you have to understand what you're giving up for what does seem at certain times to be too good to be true," Tran said.