Understanding Covered Call ETFs: Trends and Risks

Covered call exchange-traded funds (ETFs) aren’t exactly a new concept. However, there’s been a noticeable surge in the zeal with which investors are snapping them up. It feels as if there’s this “can’t miss out” attitude surrounding them that’s become almost compulsive.

The premise here is straightforward: buy a collection of stocks based on an index or through active management. This strategy delivers returns that mirror traditional stocks but comes with equivalent risks. And considering that major stock indexes offer dividend yields below 2% lately, many investors eyeing retirement savings or reliable cash flow are gravitating toward these ETFs.

What’s been puzzling me for a while is—why are they so enticing?

I’m not a complete novice to this area. In fact, I managed several mutual funds in the early 2000s that combined stocks with options strategies.

Back then, something struck me—I never considered how different the average investor is now. Once upon a time, utilizing options in ETFs or mutual funds felt more like spotting a zebra than a horse. Covered call funds have existed for decades, typically as closed-end or mutual funds, yet they never soared in popularity like today’s ETFs.

If you were to point to a leading figure in this covered call ETF sphere, it would be the JPM Equity Premium Income ETF (JEPI). J.P. Morgan’s wealth management sector didn’t initially grab headlines, but they quickly became a major player in attracting investor assets.

How did it once reach around $50 billion in assets—and still hover around $40 billion? I’d highlight three reasons, although one might raise some eyebrows. But that’s not my goal here.

1. JEPI had a standout year in 2022—its first significant performance in a while—where deft stock choices added real value amid declining markets for stocks and bonds. Despite being down only 3%, it eclipsed the S&P 500 Index. While JEPI is actively managed, its focus on large-cap stocks sets it apart. Investors tend to chase strong performance, making 2022 the start of a broader trend where JEPI continues to gather assets.
2. This showed growing interest in that specific ETF category, drawing in numerous new players, and lifting all covered call ETF standards. It also spurred others to take note, as an analysis site I contribute to often advocates for JEPI and similar funds. Yet, some individual investors still seem a bit lost in this space.
3. Then there’s the marketing angle. JPMorgan, like many firms, is engaged with Wall Street currents, which prompted JEPI’s rise to prominence—even if it often functions as a temporary fix.

Evaluating JEPI’s Worth

You’re probably expecting my typical, somewhat tedious answer to this. And here it comes: it depends on the role you’d like JEPI to play in a broader portfolio.

JEPI has plenty of initiatives toward achieving this. It boasts a robust management team with significant industry experience, the credibility of JPMorgan, and a track record that appeals to many looking to use covered call ETFs to turn stocks’ volatility into regular monthly income. However, bear in mind that its dividends don’t reflect in the price returns mentioned.

This method can highlight how sensitive an ETF like JEPI might become if its price-to-earnings ratio falls significantly, impacting its income returns.

Now, let’s dive into the flip side, which is why I felt compelled to write this. Covered call ETFs have numerous attractive traits, yet what has seen success in the past five years could face challenges going forward. In other words:

1. The yields on these ETFs seem poised for some decline. This trend is already emerging, and it could worsen. Since many funds are anchored by Treasury bills, their yield is closely tied to those rates. As the Federal Reserve slowly eases those rates, there’s risk from a still-lackluster stock market, which is where JEPI thrives. Also, because their holdings are equally distributed, it’s unlikely they will heavily invest in the top tech stocks—an element that could spell trouble if those stocks tumble, particularly for covered call ETFs that track the Nasdaq 100 Index.

1. As price returns diminish, yields could take a real hit. Many might not realize that funds like JEPI are essentially trading off some profits for a higher income return—courtesy of close-to-money covered call strategies.
2. Here’s the kicker. These ETFs offer limited downside protection. Why should that be? Well, there’s a minor cushion from option income, but if the stock market sharply declines and doesn’t bounce back, these ETFs could end up trading call options at drastically lower prices. That being said, current upside potential appears restricted—it feels almost like a trap.

Why Has This Issue Gone Unnoticed?

Simply put, if you look back at the rapid asset growth in covered call ETFs, you’ll see they’ve swiftly rebounded following market downturns, effectively camouflaging any shortcomings these funds have. I might even joke that this has “covered” their weaknesses.

I’m among the few investment writers trying to shine a light on this risk. Yet, honestly, it’s not garnering the attention it probably should. Earlier this year, I published a study revisiting past covered call funds, particularly a closed-end fund from 2007 to 2009. That period was marked by the last significant risk events like the ones I have described. It makes sense that most current investors might overlook it—or, even if they consider it, they might feel the risk is minimal.

This isn’t a critique of ETFs. In fact, I’ve noted that covered call ETFs can be effectively paired with inverse ETFs that hedge against stock price declines.

For investors who prioritize risk management, this should feel manageable. However, it’s vital to acknowledge that risks do exist.

Ultimately, I hope investors will recognize both the advantages and the potential drawbacks of covered call ETFs, allowing them to proactively guard against significant losses.