Covered call ETFs uncovered

In the ETF space, where being first and being creative is often required for success, an age-old strategy known as covered call writing has found fresh momentum in a market environment that can best be described as iffy.

The covered call strategy, which is sometimes called buy-write investing, started to gain traction during the unpleasant market of 2022, when stocks and bonds both cratered as the Federal Reserve was hiking interest rates to fight inflation and virtually everyone was bracing for some form of recession.

Enter covered call writing, neatly wrapped in the low-cost convenience of an exchange-traded fund, and financial advisors suddenly have something positive to talk with their clients about.

How else do you explain the meteoric success of the JPMorgan Equity Premium Income ETF (JEPI), which pulled in more than $16 billion over the past 12 months, is on pace to double in size this year, and doesn’t even have a three-year track record yet?

What the $21.8 billion ETF does have is an active investing strategy that buys stocks and then generates income by selling options that let the option holder buy the stock in the future at the price at which it was trading when the option was purchased.

JEPI, which is part of a tight group of covered call ETFs gaining appeal in this market, was down just 3.5% last year, while the S&P 500 Index lost 18.2%. So far this year, JEPI is lagging the broad market with a gain of 73 basis points, compared to a 5.7% gain by the S&P 500.

“The environment is well suited for these strategies and we’re likely to see more firms bring these products to market,” said Todd Rosenbluth, director of research at VettaFi.

“This is an easy to implement strategy that has been time-tested to offer strong risk-adjusted returns,” he added. “And I’m confident these ETFs do not pass along capital gains to investors.”

UPSIDE, DOWNSIDE CUSHION

Individual fund results will vary, but a certain level of upside and downside cushion is essentially what investors should expect when it comes to covered call strategies.

“These strategies are not supposed to outperform the S&P, but they will have better Sharpe ratios and pretty darn good returns,” said Hamilton Reiner, JEPI portfolio manager and head of U.S. equity derivatives at J.P. Morgan Asset Management.

As big a fan as Reiner is of his covered call fund, he said it would be a mistake to treat it as a core part of a diversified portfolio. Even though the income generated from covered calls adds to the total return, the upside performance is always limited because the stock price performance is ultimately earned by the owner of the option.

Reiner sees the strategy best suited to be either a portfolio anchor, a conservative equity allocation or  a replacement for extended credit.

“I think of it as a complement to a core portfolio,” he said. “It’s an alternative way of getting total return, because in a range-bound market this strategy will create some upside, and the worst-case scenario for this strategy is violent up or violent down markets.”

Nate Geraci, president of The ETF Store, concurred with Reiner’s word of caution that covered call funds are not something for the set-it-and-forget-it investor or financial advisor.

“It’s absolutely critical for investors to remember that covered call ETF strategies are not the same as high-quality bonds,” Geraci said. “There is meaningful downside equity risk involved with these products, which is something that shouldn’t be dismissed.”

VARIATIONS ON A THEME

While JEPI has set the pace with asset flows over the past year, several other ETFs offer variations on the same strategy, but many of them are index-based and have less portfolio flexibility than an actively managed fund.

The $2.4 billion Global X S&P 500 Covered Call ETF (XYLD) finished better than the S&P 500 last year with a 12.1% decline and is on track with the index this year with a 5.5% gain.

There’s also the $1.5 billion Global X Russell 2000 Covered Call ETF (RYLD), which lost 13.1% last year and is up 5.1% this year. The $6.8 billion Global X Nasdaq 100 Covered Call ETF (QYLD) lost 19.1% last year and is up 6.7% this year, proving how much performance can vary in the covered call space.

“Right now, covered call ETFs are in a sweet spot from a macroeconomic perspective.”

Karan Sood, chief executive, Cboe Vest

Some of the funds have been around for years, but became darlings of financial advisors and investors when they proved to be out of sync with the broader markets last year.

Consider, for example, the $2.7 billion Amplify CWP Enhanced Dividend Income ETF (DIVO), which was down just 1.5% last year and is up 21 basis points so far this year. DIVO, which is actively managed, has been around since 2017 and has nearly tripled its assets over the past 12 months.

Karan Sood, CEO of Cboe Vest, said the rising-rate environment has covered call strategies back on the map as an “alternative source of income.”

“Covered call strategies are monetizing equity volatility without the duration risk,” he said. “Something just like this played out from 2004 to 2009 when we faced a similar macroeconomic environment.”

At that time most covered call strategies were being applied inside closed-end funds, which raised billions of dollars during the Fed tightening cycle that saw interest rates spike to 5% in 2007 from around 1% in 2004, Sood said.

“We’ve seen this movie before with rates going up and classic sources of income not working,” he added. “Right now, covered call ETFs are in a sweet spot from a macroeconomic perspective, because if the market is down or sideways, it’s a good trade. The problem is, the market doesn’t go up or down in a trend line, it can go up for a week and down for a month.”

In essence, compounding doesn’t work well with covered call strategies because all the upside is being exchanged for the income premium from the sale of calls.

“As the market cratered in 2008, those closed-end funds did well on a relative basis, but when the market ripped back up starting in 2009 those funds got capped out,” Sood said. “They’re not particularly good full-market-cycle products.”

Brooks Friedrich, principal director of investment solutions strategy at Envestnet PMC, agrees covered call ETFs are not ideal for buying and holding over the long term, but he does see room to run in the current environment.

“It’s a shiny new object but in an efficient wrapper, and I think it’s part of a broader trend,” he said. “Given the volatility, expectations of U.S. stocks in next 12 to 18 months, and some kind of recession, the strategy gives you stock market exposure, which is good for people in or near retirement.”

Sumit Roy, senior ETF analyst at ETF.com, said the biggest challenge for some advisors and investors is determining where covered call ETFs fit inside a portfolio.

“This is for monthly income, but it won’t give you much in terms of appreciation,” Roy said. “Think of them as income instruments, but unlike some income instruments, they are pretty volatile because they hold the underlying. In bull markets you probably don’t want this exposure.”