Exploring Covered Call Strategies

February 08, 2018

[This article appeared in our February issue of ETF Report.]

Income-hungry investors who seek alternatives to low-yielding Treasuries, risky junk bonds or dividend-paying stocks may want to consider covered-call options strategies.

These plays give investors potential income without reaching for yield, and a modest amount of downside protection during market corrections. Usually these strategies are done in the options market against individual stocks. However, a few exchange-traded funds are trying to make these strategies easier to enact, and offer more diversification.

There are eight covered-call equity strategies in ETF form (as well as a put-write strategy), with most of them following indexes. The general theory behind covered-call option strategies is they’re essentially “insurance” products, where an investor holds a long position in an asset and writes (or “sells”) a call option to generate income. In addition to selling the equity premium, these strategies also sell volatility premiums, lowering the portfolio’s volatility, which can improve risk-adjusted returns, market watchers say.

Covered-Call Trade-off
Advisors like these products because they provide impressive yield levels. The biggest covered-call ETF by assets under management, the PowerShares S&P 500 BuyWrite Portfolio (PBP) has a yield of 10.83%. It has $334 million in AUM and an expense ratio of 75 basis points.

The next two largest ETFs in this category by AUM also have fairly sizable yields. The WisdomTree CBOE S&P 500 PutWrite Strategy Fund (PUTW) has a yield of 3.51%, $306 million in AUM and an expense ratio of 0.38%. The Horizons Nasdaq-100 Covered Call ETF (QYLD) has a yield of 7.6%, with an AUM of $190 million and an expense ratio of 0.60%.

Those yields are much greater than SPDR S&P 500 ETF Trust’s (SPY) yield of 1.8% and the PowerShares QQQ Trust’s (QQQ) yield of 0.80%. But while investors are getting that desired income, they also give up a little in asset returns. Compared with SPY, which returned 22.4% in 2017, PBP and PUTW were up 11.4% and 10.3%, respectively. QYLD was up 18%, versus QQQ’s return of 35% last year.

If higher income is one of these ETFs’ upsides, then forfeiting some of the underlying asset’s growth is one of the downsides, say issuers and users of the products. Advisors thinking about using covered-call ETFs in their clients’ portfolios for income may need to explain why the asset return is lower, especially in a year like 2017, which produced outsized returns.

Aaron Gilman, chief investment officer of Independent Financial Partners (IFP), constructs ETF portfolio strategies for the firm’s 550 financial advisors, and says he uses QYLD when opting for a covered-call ETF. He finds they’re best used for clients who are in the distribution phase of their portfolio management and are more focused on matching a certain rate of return to compensate for their withdrawal rate.

“For someone who wants a full-juice, high-octane [portfolio construction], I would never put them in a covered-call strategy,” Gilman said. “You have to match the strategy with the underlying objective and what you’re trying to do.”



Threading The Needle
Kevin Simpson, founder and portfolio manager for Capital Wealth Planning, which runs the Amplify YieldShares CWP Dividend & Option Income ETF (DIVO), an actively managed covered-call ETF, says these strategies are geared for a more conservative investor, but one who still wants to be in equities.

“It’s still a stock, and we’re still purchasing and investing in this market,” he said. “Certainly there’s still equity risk there.”

What Gilman likes about QYLD is it diversifies the portfolio by giving investors exposure to the Nasdaq-100, but with lowered volatility and higher yield. Otherwise, he notes, advisors would be “shunning an entire sector of the market because of the yield, when it comes to the constraints and specifics of the strategies we’re building.”

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