Buy-Write Funds' High Yields Obscure Some Risks

Buy-write exchanged-traded funds, which mostly use covered-call equity strategies to produce income, gained popularity last year when the Federal Reserve was hiking rates and equity and bond markets tanked. 

They continue to gather assets even as nearly risk-free Treasury notes yield 5%. The poster child for these strategies, the $28.9 billion JPMorgan Equity Premium Income ETF (JEPI), gathered $12 billion in asset flows through Oct. 2 according to ETF.com’s flows data, and is one of 2023’s top 10 of biggest ETF flow gainers.  

Yet JEPI and other equity buy-write ETFs are significantly lagging their respective indexes year-to-date. JEPI is up 3.6% versus the 13.6% gain for SPDR S&P 500 ETF Trust (SPY). Another popular buy-write ETF, the $7.8 billion Global X NASDAQ 100 Covered Call ETF (QYLD), is up 17% while the Invesco QQQ Trust (QQQ) gained 37.6%. 

Lagging in rising markets is a feature, not a bug, of buy-write strategies as covered-call ETFs sell away some or all the upside for that income. But unliked buffered funds, another popular strategy, there’s no cap for losses. Fund issuers say the strategies are a way keep otherwise equity-skittish people invested in the market while delivering high income.  

High Yields Can Blind 

Scott Opsal, director of research and equities at the Leuthold Group, which runs a portfolio of ETFs, says while “income is all the rage” for investors, they may be letting yields of 8%, 10% or 12% blind them to buy-write strategies risks.  

Investors are seeing in real-time how the strategies mute gains, but investors may not understand that they are still exposed to losses, he says. The yield gives investors a little cushion during market downturns, but they can still lose money if markets fall sharply.  

Rohan Reddy, director of research at Global X ETFs, says these strategies don’t work well in extreme up and down markets, but says investors can benefit from volatile markets because option premiums rise during volatile times. Because income is the draw, investors may be willing to sacrifice upside. 

“Some income investors might say, I just like the consistency of receiving the income,” he says. 

Some newer ETF buy-write strategies try to avoid completely limiting gains, such as the $466.9 million FT Cboe Vest Rising Dividend Achievers Target Income ETF (RDVI), launched almost exactly a year ago. It targets an eight-percentage point yield above the S&P 500 dividend yield, less fees, and uses weekly options to pump up the yield. It’s up 4.9% year-to-date. 

Ryan Issakainen, exchange-traded fund strategist at First Trust, says because of how options work, higher market volatility means they can hit the income target with less overwriting of the portfolio, allowing more participation in the market. But he also agrees that these ETFs only cushion investors from market downside, not buffer their losses.  

JPMorgan didn’t return a request for an interview. 

Price Return vs. Total Return 

Reddy and Issakainen say investors usually buy these funds for their monthly income distribution, rather than reinvesting dividends. However, Opsal says taking the income significantly affects total return, since that figure reflects reinvesting income.  

Price return may give a more realistic return picture for income investors spending their distributions, without doing complicated modeling to get their exact returns. 

For example, the total return for QYLD is 15.4%, while the price return QYLD is 6.8%. For RDVY its total return is 6.5% and price return was 3.1%.  

Opsal says income investors should keep an eye on the net asset value. “They need to make sure they understand they own a wasting asset. Any time there’s a bear market, that NAV will go down, then it doesn't go back up in a bull because you've sold off the upside for the next run,” he says. 

Note: Corrects ninth paragraph to include FT Cboe Vest Rising Dividend Achievers Target Income ETF (RDVI) and remove First Trust Rising Dividend Achievers ETF (RDVY)