As exchange-traded funds (ETFs) with covered call strategies gain momentum among retail investors, finance experts say these products come with a trade-off. Proponents of these investments say they can be a helpful tool for income-focused investors, while opposers say they result in lower longer-term returns and shouldn’t be a core investment holding.
Prerna Mathews, vice-president of ETF product strategy at Mackenzie Investments, said covered call ETFs typically invest in dividend-paying equities and further enhance income by writing call options on those holdings. A call option provides the right to purchase a security at a set price. She said covered call ETFs essentially earn option premiums in exchange for “giving up” some of the stock’s future gains beyond the set option price.
She noted covered call ETFs have flourished in the market recently, fuelled by investor enthusiasm for their higher yields. Mathews said these products can be attractive to those who prioritize income over growth and help manage market volatility.
“There’s definitely a trade-off; there’s no free lunch. The higher yield off the options premiums is coming off of the fact that you are giving up long-term return in the stock,” Mathews said. “Those options premiums, you’re getting paid out on them today, but that total return impact is usually much more significant than the yield that you’re actually generating off of them.”
Mathews said there is more onus on investors to do due diligence and not get “distracted by a flashy yield number and marketing material.”
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Covered call ETFs offer income—but at a cost
Fred Masters, president of Masters Money Management Inc., said the best way to view these products is to think of them as “enhanced income products” that use options strategies to boost their yields. He said retail investors shouldn’t base their portfolios around these products, pointing to higher fees and lower overall returns. Though he said they can work as a smaller part of a larger portfolio.
Masters highlighted that management fees for these products can be “up to ten times higher” than a typical ETF in the same category.
“You can’t control outcomes in many cases when investing in equity markets, but you can control costs and keeping costs to a minimum year after year is a crucial tenet of long-term investing success,” he said. “We know these covered call ETFs are expensive and that eats into returns annually.”
Covered call ETFs can shine when markets stall but lag in rallies
Covered call ETFs can perform better under certain market conditions though, according to Nick Hearne, a financial adviser and portfolio manager at RGF Integrated Wealth Management. In a range-bound market, where stocks are moderately increasing, and in declining markets, he said covered call ETFs will often outperform traditional strategies due to the income investors receive.
“Where they’re going to underperform is when the market increases significantly over a period of time … what they’re really doing is when they sell those call options, they’re selling their upside. That’s the downside,” Hearne said. “And over the long term, (covered call ETF investors) have less exposure to the market because they are selling part of their exposure, and so the expectation would be that a long-only or traditional strategy would outperform a covered call strategy.”
Steady payouts attract retirees despite added market risk
Mathews said covered call ETFs can be suited to investors prioritizing income, including people in retirement who can’t handle as much volatility in their portfolio. “Fixed income will only get you so far. In 1995, you could generate a 6% yield off of just Treasuries and investment-grade (bonds). And today, getting to that same 6% yield is so much more challenging,” she said.
However, investors choosing this path are taking on a higher level of risk through covered call exposure compared with fixed income, Mathews noted.
Despite any trade-offs, covered call ETFs have been gaining momentum in the market. Mathews said there are 17 providers that offer covered call products in Canada, with over $35 billion allocated to covered call ETFs as of September. “We continue to see very strong flows even year-to-date into these products and, unsurprisingly, with an aging demographic in Canada, we’re seeing that trend persist,” she said.
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