Prerna Mathews, vice chairman of ETF product strategy at Mackenzie Investments, said covered call ETFs typically spend money on dividend stocks and further boost returns by selling call options on those holdings. A call option gives the fitting to buy a security at a specified price. She said covered call ETFs essentially earn option premiums in return for “forgoing” a portion of the stock’s future gains beyond the required option price.
She noted that covered call ETFs have flourished out there recently, driven by investor enthusiasm for his or her higher returns. Mathews said these products might be attractive to those that prioritize income over growth and help manage market volatility.
“There’s definitely a trade-off; there’s no such thing as a free lunch. The higher return on option premiums comes from the fact that you’re forgoing the long-term return of the stock,” Mathews said. “These option premiums are paid to you today, but the impact on total returns is usually much more significant than the return you actually earn on them.”
Mathews said there may be a greater obligation for investors to conduct due diligence and never be “distracted by flashy return numbers and marketing material.”
Covered call ETFs offer income – but at a price
Fred Masters, president of Masters Money Management Inc., said one of the best approach to have a look at these products is to think about them as “higher-income products” that use options strategies to spice up their returns. He said retail investors shouldn’t base their portfolios on these products, citing higher fees and lower overall returns. However, he said they might work as a smaller part of a bigger portfolio.
Masters emphasized that management fees for these products could be “up to 10 times higher” than a typical ETF in the identical category.
“When investing in stock markets, in many cases you can’t control the results, but you can control the costs, and keeping costs to a minimum year after year is a crucial principle for long-term investment success,” he said. “We know that these covered call ETFs are expensive and that reduces annual returns.”
Covered call ETFs can shine when markets falter but lag during rallies
However, in accordance with Nick Hearne, financial advisor and portfolio manager at RGF Integrated Wealth Management, covered call ETFs can perform higher in certain market conditions. He said covered call ETFs will often outperform traditional strategies in a volatile market where stocks rise moderately and in declining markets due to income investors receive.
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“They’re going to underperform if the market goes up significantly over a sustained period of time…What they’re really doing is when they sell these call options, they’re selling their advantages. That’s the downside,” Hearne said. “And in the long term, (covered call ETF investors) have less exposure to the market because they are selling some of their exposure, and therefore it would be expected that a long-only or traditional strategy would outperform a covered call strategy.”
Despite increased market risk, stable payouts attract retirees
Mathews said covered call ETFs might be suitable for investors who prioritize income, including retired individuals who cannot handle such high volatility of their portfolio. “You can only go so far with fixed income. In 1995, you could get a 6% return on government bonds and investment grade bonds alone. And today it’s much harder to get that same 6% return,” she said.
However, investors who select this route tackle more risk through covered call exposure in comparison with fixed income, Mathews noted.
Despite all of the compromises, covered call ETFs have gained momentum out there. Mathews said there are 17 providers offering covered call products in Canada, with over $35 billion committed to covered call ETFs in September. “Even since the start of the year, we continue to see very strong inflows into these products and it is not surprising that this trend continues given Canada’s aging population,” she said.
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