Who doesn’t like the sound of an 8 per cent – or higher – yield and less risk than stocks?
I’ve been getting a lot of questions about covered call ETFs as a way to safely generate high income yields. My consistent answer for most investors? Stay far away from these products.
Covered call ETFs create an alluring image of high income and low risk, but these perceived attributes are a sleight of hand in financial product design. The final blow, in my view, is their high fees and costs and unfavourable tax implications.
Let’s start by understanding the strategy.
Call options are financial contracts that give the buyer the right, but not the obligation, to purchase a security at a set price, called the strike price. A call option that is “in the money” can be exercised to purchase the underlying security below its market price.
A covered call is a strategy where the option seller sells a call option on a stock that they own, receiving an option premium in return. These premiums feel like income, but there’s more to the story.
The option seller is obligated to sell their stock to the option buyer at the strike price if the option is exercised, giving up all of the upside above that price.
Lesson 1: Covered calls do not generate income; they trade option premiums for forgone expected returns.
The loss of upside potential with covered calls can exceed the premium income earned when the option was sold. This reality is easily missed when returns from capital and returns from income are considered separately, as opposed to assessing the strategy’s total return.
Take the Global X S&P 500 Covered Call ETF and the SPDR S&P 500 ETF Trust, both U.S.-listed ETFs. The covered call strategy has an income yield of 10.9 per cent at the time of writing because of its option-premium income but trails the total returns of the index fund. That’s because, in this example, the income from options premiums on the covered call ETF has been more than offset by missing gains on the index, which the index fund captures.
Lesson 2: Covered calls only have attractive risk-adjusted returns when risk is inadequately measured.
Now you might think that I’m missing the point – that covered calls have higher risk-adjusted returns, when risk is measured by standard deviation, or how dispersed returns are around the average return. This appears true on the surface, but risk measurement gets complicated with options. Covered calls put a cap on how high your returns can be because returns above the strike price are given up, but they do not offer any meaningful downside protection beyond a small boost from option premiums.
The result of capping returns above the strike price with a covered call is a reduction in standard deviation, combined with the potential for extreme negative returns, and no potential for extreme positive returns. This is called negative skewness, and like volatility, it is a risk that investors care about. Investors often assess risk using standard deviation, but covered calls are effectively trading some standard deviation for skewness. With a covered call, risk is being transformed, but not reduced.
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Using performance evaluation metrics that account for skewness shows that covered calls are not delivering anything special on a risk-adjusted basis.
Lesson 3: Covered calls come with higher fees, costs and taxes than plain index funds
The last point to understand is that covered calls come with higher fees, costs and (for taxable investors) taxes than an otherwise comparable index fund. These costs might be worthwhile for a superior strategy, but as we have seen, covered calls are not a free lunch.
Covered-call ETFs do have high yields, but they come with an offsetting liability. They do tend to be less volatile, but volatility is insufficient to measure their risk. Finally, covered call ETFs will tend to have higher fees and costs than a typical total market ETF.
For investors hoping to reduce risk in a portfolio of stocks, a more efficient approach than covered calls is simply reducing your exposure to stocks.
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Benjamin Felix is a Portfolio Manager and Head of Research at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is s a CFP® professional and a CFA® charterholder.