If you’re an advisor, you’ve likely consumed content or fielded client inquiries regarding covered call exchange traded funds, probably more so over the past couple of years than at any previous time. If you’re a retail investor, chances are you’ve at least heard of some of these products or have even reached intermediate or advanced levels of knowledge.
Enthusiasm for options-based ETFs (there are more than covered call funds, but that’s the phrase that will be used in this article) has swelled over the past few years for multiple reasons. First, there’s the obvious catalyst of out-sized yields. It’s common for covered call ETFs to sport double-digit yields. Some even go deep into that territory or beyond. That’s alluring, particularly when ETFs (iShares products) tracking the S&P 500 and the Bloomberg US Aggregate Bond Index sport trailing 12-month yields of 1. 29% and 3. 84%, respectively.
Speaking of bonds, some retail investors embrace covered call ETFs over bond funds on the basis of higher yields (true) and the perception that because options ETFs aren’t rooted in bonds, those products can act as buffers when interest rates rise (not always true as confirmed by 2022 price action).
That is to say options-based ETFs aren’t perfect for all investors, but at a time when rate risk is elevated and broad gauges of domestic equities are throwing off scant yields, interest in covered call ETFs is bound to remain high.
Interesting Facts About Covered Call ETFs
Over the past three years, more than $100 billion flowed into covered call ETFs. That momentum has benefited a variety of issuers, including YieldMax. Put it this way. The issuer introduced its first covered call ETF – the YieldMax TSLA Option Income Strategy ETF (TSLY) – in November 2022. Today, the issuer has $17. 6 billion in assets under management and accounts for five of the 10 largest funds in this category.
However, covered call ETFs aren’t a new concept. The Invesco S&P 500 BuyWrite ETF (PBP) turns 18 years old in December. PBP is worth remembering because it arguably inspired the more “tame” versions of covered call ETFs, which today are among the largest funds in the category.
“Tame” meaning ETFs that write call options on basic, well-known equity indexes while still featuring tempting though not over-the-top yields. Products in this space include the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ), Global X Nasdaq 100 Covered Call ETF (QYLD) and the Global X S&P 500 Covered Call ETF (XYLD). Those are three of the four largest covered call ETFs and the average yield on the trio is just under 13%.
Those ETFs cap upside with the “reward” to investors being significantly higher yields than what’s typically founds with bonds or dividend stocks. Then there’s the stratosphere occupied by YieldMax ETFs and some rivals. Take the case of the YieldMax MSTR Option Income Strategy ETF (MSTY) – the issuer’s largest product.
Home to $5. 58 billion in assets under management, MSTY sports an eye-popping dividend yield of 132. 46%. In other words, the latter number arguably explains the former. As tempting as that distribution rate is, it comes with a cost. The issuer, to its credit, overtly states MSTY not only has capped upside, but it has the potential to be more volatile than the underlying security – in this case Strategy (MSTR).
Investors also need to understand that those big distributions come out of the net asset value of the fund question. It’s a big reason why over the past year, MSTY (red line) traded lower while shares of Strategy (green line) surged.
(Chart Courtesy: Seeking Alpha)
Making the Cover Call ETF Call
For plenty of investors, sprinkling some capital into a product such as the JP Morgan Equity Premium Income ETF (JEPI) is sensible as a complement to equity and fixed income. JEPI sports a Morningstar Medalist Rating of Bronze.
When it comes to the MSTY’s and TSLY’s of the covered call ETF realm, income seekers need to perform due diligence and assess individual risk tolerance. In other words, they need to fully comprehend that they’re collecting big distributions while the price of the ETF likely declines.
“If I’m young, and I’ve got the risk tolerance and everything like that, you’re better off just being in sort of a low-cost S&P 500 ETF or something like that, right, where most of your gains are going to be price appreciation, and it’s going to be a little bit riskier,” says Morningstar’s Daniel Sotiroff. “That’s the really big thing I think that most people should take away. These are not great long-term investments if you’re in that accumulation phase of your financial plan in life. ”