Growing Interest in Covered Call ETFs: Weighing Benefits and Risks
As retail investors increasingly gravitate towards exchange-traded funds (ETFs) that employ covered call strategies, experts are cautioning that there are trade-offs to consider.
Supporters claim these investments are a valuable option for those seeking income, while critics suggest they may lead to reduced long-term returns and shouldn’t form the backbone of one’s investment portfolio.
Prerna Matthews, who is involved in ETF product strategy at Mackenzie Investments, explains that covered call ETFs often focus on high-dividend stocks, adding call options to these assets to help enhance returns. Essentially, a call option gives the purchaser the right to buy a stock at a predetermined price, meaning that these ETFs essentially accept option premiums in exchange for relinquishing some of the stock’s potential future gains beyond that set price.
Matthews notes that there has been a recent surge in popularity for these ETFs, driven by a strong demand for higher yields. She adds that they may particularly appeal to those who place a greater emphasis on income than on growth, and can also serve to help navigate market turbulence.
“There’s clearly a trade-off. No one gets something for nothing. The attractive yield from the option premium comes at the cost of forfeiting the long-term advantages of holding the stock,” she remarked.
Matthews indicated that while the premium earned from the options can be substantial, it often has a more significant effect on the total return than the yield itself might suggest.
She further emphasized that it’s crucial for investors to perform their due diligence and not be swayed by eye-catching yield figures and marketing tactics.
Fred Masters, president of Masters Money Management, likens these products to “income-enhancing products” that utilize option strategies to boost yields.
While recommending that retail investors exercise caution in fabricating their portfolios around these ETFs, he considers them useful as part of a larger investment strategy. He also pointed out that management fees may be “up to 10 times higher” than typical ETFs in the same category.
“You can’t control market results when investing, but you can manage your expenses,” he asserted, emphasizing that keeping costs low is essential for successful long-term investments.
He added, “We know these covered call ETFs are costly, and that impacts annual returns.”
Nick Hahn, a financial advisor and portfolio manager at RGF Integrated Wealth Management, pointed out that in certain market conditions—such as sideways or declining markets—covered call ETFs can outperform conventional strategies, primarily due to the income they generate for investors.
“Where they tend to fall short is during robust market rallies. When selling a call option, you’re essentially capping your upside potential,” Hahn explained. “In the long term, covered call investors might have less overall market exposure because they’re selling off some of their holdings.”
Matthews shared that these ETFs can suit investors focused on income, like retirees who may find it difficult to manage high volatility in their investments.
“Bonds alone have their limitations. Back in 1995, U.S. Treasuries and investment-grade bonds could easily yield around 6%. Nowadays, achieving that same yield is quite a challenge,” she observed.
However, Matthews cautioned that opting for covered call strategies involves a greater level of risk compared to bonds.
Still, the market presence of covered call ETFs continues to grow. Matthews reported that there are currently 17 providers of such products in Canada, with over $35 billion allocated to covered call ETFs as of September.
“So far this year, we’re seeing a strong influx into these products. This is indicative of Canada’s aging population and the trends that follow,” she noted.
