Covered call ETFs have become increasingly popular among investors who are looking for higher yields and more consistent cash flow from equity investments. These funds use a specific options strategy that can help generate extra income, but they also come with certain trade-offs that financial advisors should know.
In this article, Wealth Professional Canada will discuss what covered call ETFs are and what you need to consider before recommending them to their clients. We will also look at benefits, risks, and whether this strategy is more suited for bullish or bearish market views.
A covered call exchange-traded fund or ETF is a type of fund that combines traditional stock ownership with an options strategy called the covered call. The main goal is to provide investors with two sources of cash flow:
This approach is often called a cash flow enhancement strategy because it can generate more income than simply holding the stocks alone.
The covered call ETF holds a portfolio of stocks and sells call options on those stocks. The premiums collected from selling these options are distributed to ETF holders, usually on a monthly basis. This extra income comes on top of any dividends paid by the underlying companies.
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As mentioned above, covered call ETFs use call options to generate additional income by writing calls on the underlying stocks they hold. Call options are a type of derivative because their value is derived from the price of an underlying asset.
To understand covered call ETFs, it helps to first learn how a covered call works. A call option gives the buyer the right, but not the obligation, to purchase a stock at a specific price (the strike price) within a set period.
The seller of the call option, often called the call writer, receives a premium. This is for taking on the obligation to sell the stock if the buyer chooses to exercise the option.
In a covered call strategy, the investor owns the underlying stock and sells a call option on that stock. This means the investor is "covered" because they already hold the shares that might need to be delivered if the option is exercised. The premium received from selling the call option provides extra income.
Suppose your client owns 100 shares of a stock trading at $60 per share, for a total investment of $6,000. The portfolio manager writes an at-the-money call option (strike price of $60) that expires in one month and receives a premium of $1.50 per share, or $150 in total.
If the stock price stays at $60 or drops, the option expires worthless and your client keeps both the shares and the premium. If the stock price rises above $60, say to $62, the option is exercised. Your client is then required to sell the shares at $60.
In this case, your client still keeps the premium, but any gains above the strike price are given up.
Covered call ETFs apply this strategy across a portfolio of stocks, collecting premiums from multiple call options and distributing the income to ETF holders. This can result in higher yields compared to traditional equity ETFs, especially in flat or modestly rising markets.
Covered call ETFs are usually suited for investors who are focused on cash flow and are looking for a higher yield than traditional equity investments. This might include retirees or those who need regular income from their portfolios.
The strategy can also appeal to those who want to reduce volatility without giving up all exposure to equities.
Safety is a relative concept in investing and covered call ETFs are no exception. These funds are designed to reduce risk compared to owning stocks outright, but they are not risk-free.
The main way they manage risk is by generating extra income from option premiums, which can help offset losses during market downturns. This income can soften the blow if stock prices fall, but it does not eliminate the risk of loss.
Covered call ETFs have an asymmetrical risk-return profile. While they can provide steady income, they also cap potential gains. If the market rallies strongly, the ETF will not capture all the upside. This is because the call options sold will be exercised, forcing the fund to sell stocks at the strike price. As such, your clients might miss out on large gains during bull markets.
Another consideration is tax. Covered call ETFs usually pay out a mix of:
Eligible dividends are taxed at a lower rate but return of capital distributions lower the cost basis of the investment. This could lead to larger capital gains taxes when the ETF is eventually sold.
As a financial advisor, you should make sure that your clients are aware of these tax implications to avoid surprises at tax time.
There are several reasons why your clients might consider covered call ETFs:
Despite their benefits, covered call ETFs also have some drawbacks that financial advisors should keep in mind:
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The covered call strategy is best suited for neutral to moderately bullish market conditions. This approach can work well when stock prices are expected to stay flat or rise slightly. In these situations, the premium income from selling call options adds to the total return without giving up much upside.
If the market is strongly bullish, covered call ETFs might underperform. This is because the call options sold by the ETF cap the upside. When the underlying stocks rise sharply, the ETF is forced to sell them at the strike price, missing out on further gains.
In other words, your clients will not fully participate in a strong rally.
On the other hand, if the market is bearish and stock prices fall, the premium income from the options can help offset some of the losses. However, the ETF will still lose value if the decline is huge. The covered call strategy does not provide full downside protection.
This is why you need to communicate with your clients before recommending covered call ETFs. These funds are not designed for those who want to maximize gains in a bull market or those who need complete protection in a bear market.
Instead, they are best for investors who value steady income and are comfortable with giving up some upside in exchange for lower volatility.
Covered call ETFs can offer you a way to help your clients boost portfolio income and reduce volatility. However, they also come with trade-offs, including capped upside and potential tax complexity. As such, you must take the time to explain who they are best suited for and what risks are involved.
While covered call ETFs are not a one-size-fits-all solution, for the right investor, they can be a valuable addition to a well-diversified portfolio. These funds work best for those who want higher cash flow and are comfortable with the idea that strong market rallies might leave them with less upside.
Make sure that your clients also understand how distributions are taxed and that return of capital can affect their cost base over time. This way, they can decide if the steady income and lower volatility are worth the trade-offs in their specific situation.
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