Covered call ETFs have high returns, but come with a trade-off: MoneySense

Prerna Mathews, vice president of ETF product strategy at Mackenzie Investments, said covered call ETFs typically invest in dividend-paying stocks and further boost income by writing call options on those holdings. A call option gives the right to buy a security at a fixed price. She said covered call ETFs essentially earn option premiums in exchange for “giving up” a portion of the stock’s future gains above the set option price.

She noted that covered call ETFs have been booming in the market lately, fueled by investor enthusiasm for their higher returns. Mathews said these products could appeal to those who prioritize income over growth and help manage market volatility.

“There’s definitely a trade-off; there’s no free lunch. The higher return on the option premiums comes from the fact that you’re giving up the long-term return on the stock,” Mathews said. “You get paid those option premiums today, but the impact on the total return is usually much greater than the return you actually generate with them.”

Mathews said there is more pressure on investors to do due diligence and not be “distracted by a flashy return figure and marketing material.”

Covered call ETFs provide income, but at a cost

Fred Masters, president of Masters Money Management Inc., said the best way to look at these products is to think of them as “higher income products” that use options strategies to boost their returns. He said retail investors should not base their portfolios on these products, pointing to higher fees and lower total returns. Although he said they can work as a smaller part of a larger portfolio.

Masters highlighted that management fees for these products can be “up to ten times higher” than for a typical ETF in the same category.

“You can’t control the outcomes in many cases when you invest in the stock markets, but controlling costs and keeping costs to a minimum year after year is a critical principle for long-term success in investing,” he said. “We know that these covered call ETFs are expensive and that this comes at the expense of returns every year.”

Covered call ETFs can excel when markets are stagnant, but underperform during rallies

However, covered call ETFs can outperform under certain market conditions, according to Nick Hearne, financial advisor and portfolio manager at RGF Integrated Wealth Management. In a bandwidth-constrained market, where stock prices are rising moderately, and in bear markets, he says covered call ETFs will often outperform traditional strategies because of the income investors receive.

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“The point where they start to underperform is when the market goes up significantly over time… what they’re really doing is when they sell those call options, they’re selling their upside. That’s the downside,” Hearne says. “And over the long term, (covered call ETF investors) have less exposure to the market because they are selling some of their exposure, and so the expectation would be that a long-only or traditional strategy would outperform a covered call strategy.”

Steady payouts attract retirees despite increased market risk

Mathews said covered call ETFs may be suitable for investors who prioritize income, including people in retirement who can’t handle as much volatility in their portfolio. “Fixed income only gets you so far. In 1995 you could get a 6% return from just government bonds and investment grade (bonds). And today it’s so much harder to get that same 6% return,” she says.

However, investors who choose this path face a higher level of risk through covered call exposures compared to fixed income, Mathews noted.

Despite any tradeoffs, covered call ETFs are gaining momentum in the market. Mathews said there are 17 providers offering covered call products in Canada, with more than $35 billion allocated to covered call ETFs as of September. “We continue to see very strong flows in these products to date, and it is not surprising that given Canada’s aging population, we see this trend continuing,” she said.

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