Even by the high-growth standards of the world of actively managed exchange-traded funds, the boom in a new breed of option-linked, income-generating funds known as covered-call funds has been dazzling.
Since 2022, nearly 80 have been launched, according to investment research firm Morningstar, and $65 billion of net inflows have poured into them.
The attraction of these ETFs, often dubbed "boomer candy," is understandable. Through some financial engineering, they can provide relatively high and steady levels of monthly income (annual yields in the low-double-digit percentages are common) even when linked to an index such as the Nasdaq, whose stock components pay negligible dividends. Moreover, covered-call funds have the effect of tamping down volatility of the stocks or indexes they track.
At the same time, many financial advisers are skeptical whether investors adequately grasp the trade-offs entailed in what they're buying. "There are things that investors probably don't totally understand when they buy and hold covered calls," says Jonathan Treussard, founder of Treussard Capital Management. "For example, are you okay with giving up market upside but retaining downside risk in exchange for income?"
Before we look at some of the pros and cons of this burgeoning corner of the ETF universe, let's briefly examine how they work. (There are a multitude of different strategies of varying complexity, but we'll use a simple example to illustrate the dynamics.) An investor can sell (or write) a call option, a form of derivative, on an individual stock or on a market index such as the S&P 500.
An option contract gives the buyer the right to buy a security at a set price within a specified period. Let's say you write (sell) an option on a stock you own that expires a month from now at a stipulated "strike price" 5% higher than today's share price. If the market price rises to the strike price at the end of the one-month contract period, the option is "in the money" and the stock will be assigned (or called) to someone who buys or already holds the option contract. (Technically, in most cases, the stock may also be called prior to the end of the contract period.) The seller earns premium income from selling the call but has forfeited any price gain in the shares above the strike price.
Covered-call funds: the caveats
Bearing in mind the diversity of covered-call (also called buy-write) strategies, they have some characteristics in common. They will underperform their underlying indexes in bull markets, they will slide in bear markets but be slightly buffered due to the income from call premiums, and they may outperform in markets that move sideways.
For example, Morningstar calculates that since 2020, derivative-income ETFs tracking the S&P 500 captured a median 60% of the benchmark's gain (47% for those tied to the Nasdaq), while the ETFs experienced 72% of the index's downdrafts (60% for the Nasdaq).
Due to the math of compounding, the performance gap can be large over time: Simeon Hyman, global investment strategist for ProShares, says that over time, a typical monthly covered-call strategy will generate only one-third to one-half of the stock market's return. "If you don’t need the income, you don't need covered-call strategies," Hyman says.
The volatility of the funds is lower than that of the underlying index. Indeed, part of the appeal is that option-based strategies "monetize the volatility," because the greater the volatility in the index or stock, the higher the option value and, hence, the greater the income you'll earn. Thus, option income from calls written on the more-volatile, tech-laden Nasdaq and small-cap Russell 2000 Index tends to support higher monthly yields than on the less-jumpy Dow Jones Industrial Average and S&P 500 Index.
On the flip side, taxation of income generated by these funds tends to be high and often complex. (Depending on the implementation of option strategies, all the option income may be taxed as ordinary income.)
"It's very important to understand that, by and large, covered-call ETFs tend to be an order of magnitude less tax efficient than plain-vanilla ETFs, and in a way that isn't understood by the investing public," says Treussard.
How much less tax efficient? Brent Sullivan of Tax Alpha Insider, a tax and investment consultancy, compared the tax drag of one of the largest covered-call S&P 500 ETFs with that of the Vanguard S&P 500 ETF during the three-year period through September 30. Using Morningstar's Tax Cost Ratio, a metric that captures the impact of taxes on a fund's annualized return, he found that the tax cost for the covered-call funds was seven times higher.
"With these products, you are giving up what would be unrealized capital gains in favor of current income, which is punitively taxed," says Sullivan.
So why are these funds so popular, and how should they be used in a diversified investment portfolio? "The driving factor is investors looking for alternative sources of income," says Robert Scrudato, director of options and income research at Global X ETFs. Treussard notes that two cohorts who seek such income are baby boomers entering or in retirement and people who have made a pile of money and seek to generate good income on their wealth, even at the cost of forfeiting a large portion of expected long-term stock-market returns.
One way to address the knotty tax issues, of course, is to hold these derivative income funds in an IRA (or better yet, a Roth IRA) or other tax-deferred account. Hyman suggests a strategy of using this income in a tax-sheltered account to fund annual distributions from the account.
Those who prefer to hold the funds in a taxable account– perhaps to meet spending needs with the monthly distributions – should investigate the nature of the monthly distributions and understand how they're classified for tax purposes before investing.
For instance, the option income, depending on the type, may all be classified as ordinary income, or it may enjoy a 60% long-term, 40% short-term treatment (regardless of the holding period) under IRS rules; stock-dividend income may or may not enjoy the preferential tax rates available for qualified dividends; and some of the distribution may be a return of capital, which isn't taxed today.
With all these caveats, here are several ETFs worth exploring. All figures are as of September 30, unless otherwise noted.
JPMorgan Equity Premium Income ETF
With assets of $36 billion and mounting, the JPMorgan Equity Premium Income ETF (JEPI) bestrides the industry like a colossus. The portfolio, drawing on firmwide fundamental analysis, is an actively managed mix of about 130 securities that comanager Hamilton Reiner describes as "a more-defensive, higher-quality group of stocks – names with predictable earnings." Top positions include HVAC equipment maker Trane Technologies (TT) and Progressive (PGR), the insurance giant.
Instead of selling call options on the S&P index, the fund achieves the same goal through employing a different derivative instrument: equity-linked notes (ELNs). The fund has pretty much delivered on its stated goal of providing an annual yield of 7% to 9% with monthly distributions (the current yield is 7.8%). Those payouts are partially stock dividends but are predominantly monthly income from ELNs, which is taxed as ordinary income.
So far this year, the fund has returned 13.4%, compared with the S&P 500's 22.1%. The fund earned its spurs in parlous 2022, when it slipped only 3.5% thanks to both its conservative stock portfolio and its option income; the broad market, in comparison, plunged 18%.
JPMorgan Nasdaq Equity Premium Income ETF
JEPI’s sister fund, the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ), has garnered $17 billion in assets since its inception in 2022. JEPQ is run very similarly except that its portfolio adheres more closely to its underlying index, the Nasdaq-100, and is less actively managed.
Due to Nasdaq's higher volatility, the target yield is 9% to 11% (current yield: 9.3%). Reiner notes that JEPQ appeals to investors who want to hold growth stocks but can't take the volatility or lack of income available in the Nasdaq.
NEOS S&P 500 High Income ETF
The NEOS S&P 500 High Income ETF (SPYI) holds all the stocks in the large-company index, then sells call options on the index. The fund maintains an average option contract duration of six to seven weeks, says comanager Troy Cates. It also seeks to reduce or defer taxation through use of Section 1256 contracts (named for the IRS code that governs them) and through active portfolio tax management that includes tax-loss harvesting.
The fund aims to yield 10% to 12% (current yield: 11.7%). Its one-year return is 23%, compared with the S&P 500's 36.4%.
S&P 500 High Income ETF
Launched in December 2023, the S&P 500 High Income ETF (ISPY) is off to a strong start. Instead of selling monthly options, the ProShares fund sells daily options, which became available only relatively recently. The advantage of daily options is that besides generating premiums daily, they reset the cap on market upside daily, allowing investors to capture more of the market's gains.
"With a daily covered call, you're at bat every morning," says ProShares' Hyman. Since it launched, the ProShares offering has returned 20.5%, compared with 22.9% for the S&P.
The fund's monthly distribution tends to bounce around, but the current annualized yield is 9.1%. This year, ProShares also launched ETFs with the same daily option strategy on the Nasdaq-100 and Russell 2000 indexes.
Westwood Salient Enhanced Midstream Income ETF
The Westwood Salient Enhanced Midstream Income ETF's (MDST) energy infrastructure portfolio with an options overlay benefits from a hot midstream-energy sector, with average dividend yields of 5% to 6%.
Comanager Greg Reid says the fund writes monthly calls, on a rolling basis, on each of the roughly 25 U.S. and Canadian stocks and master limited partnerships (MLPs) in the portfolio. Since the dividend income is quite predictable, the ETF distributes exactly $0.225 per share each month, which currently equates to an annual yield of 10.4%.
Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
