Covered Call ETFs: Are they worth investing in?

I have bought and sold stocks since I was nine years old. I bought QQQ at its peak. I bought Apple (wish I bought more!) in 2008, and I’ve spent more time reading, watching, and thinking about Economics, and the stock market than I care to admit. I’ve seen and heard a lot of seminal swings and cycles not only in public markets, but also in the everyday economy. One of the newer innovations in the stock market and trading is ETFs. The easy way to think about ETFs is that they are the same thing as holding mutual fund shares, except they are a little more tax efficient and can be traded all day. Mutual fund trades are processed once, at the end of every trading day. The introduction of ETFs has led to an explosion of thematic, specialized ETFs, to go along with passive ETFs that simply track an index. You can buy ETFs that track a sector. You can buy ETFs from a specific asset manager. You can buy international ETFs. You can pretty much find an ETF for whatever you want. One type of ETF I’ve come across is covered-call ETFs.

I don’t know how, but tweets (yes I go on Twitter. Yes, I'm working on limiting my scrolling habit. No I’m not sure what to do when scroll cravings hit.) about high yield ETFs somehow found their way into my feed. Naturally I was curious about how an ETF could generate a 10% to 40% distribution yield. The prevailing wisdom I always heard was don’t chase yield. And if you did chase yield it would come at the expense of price growth, or it was a trap. So, if I bought a stock, mutual fund, or ETF I never bought anything that yielded more than about three percent. That has been more or less the agreed upon line of demarcation for investors. Up to about three or four percent, you can still get a healthy amount of price appreciation, while also getting a decent yield.

Covered call ETFs achieve their higher yield by selling calls, which is a type of derivative known as an option contract, against the securities the ETF is holding. Buying a call is done with the expectation the price of an underlying asset will go up. By selling calls, the ETF providers collect premiums from the buyers. They then turn around and distribute that income to shareholders every month, although some do this every week. I have thought about selling calls against the holdings that I own, but never did so because I’d have to manage too many moving parts I don’t know enough about with too little payoff. The thought of having investment professionals who manage billion dollar ETFs with years of investing experience managing the option activity for me and benefitting from a dependably higher yield is awfully enticing.

So I dug into them. Between the hype they get on social media and the criticism they take from mainstream outlets, I wanted to see who was right. Similar to the overall ETF market, there’s an awful lot of covered-call ETF variety. There are single-stock covered-call ETFs and everything in between. There are asset managers you have likely never heard of, and a lot of them. There’s many different structures. Some use a different derivative to generate income called a put. This is a nascent category. Some ETFs have been around for more than a decade. Others much shorter. Long story short: like the attention they’ve gotten, there’s a lot of noise.

After looking at all the covered-call ETFs I’ve seen, I would only feel comfortable putting money into two. Full disclosure: I don’t have any money invested in any covered call ETFs, but I might in the future.

There are many items to take into consideration when it comes to covered-call ETFs. The first is who is the asset manager and what can you infer from their website. You’re trying to figure out if you would trust them to manage your money. A lot of asset managers issuing these ETFs are smaller, maybe less well-known, and in some cases have a shorter track record than the bigger blue-chip firms also offering covered-call ETFs. They are actively managing the ETFs, so some decisions need to be made about the fund and you have to trust they will make good decisions. The second is fees. This is something I don’t see talked about on social media. Covered-call ETFs are income products. They are designed to be held by investors for a considerable period of time. High ETF expense ratios and trading fees eat into returns considerably.

The vast majority of covered-call ETFs have expense ratios of .65% to 1.03%. Fees closer to .65% are much easier to stomach than those closer to 1.03%. But those fees closer to 1% will take roughly ⅓ of your returns away over a 30-year time horizon. That's a gigantic amount. Even over shorter holding periods, I'm not willing to fork over a bunch of money in expense ratio, especially for a fund manager I do not trust to actively manage any part of my money. The third is how the ETF is structured. There's a lot of questions with this item you'll have to answer like: what percentage of the ETF do they write calls against? How much of a gap is there between the price of the underlying and the strike price of the options they sell? (This helps you figure out how much price appreciation the fund captures before the call they sold will result in an exercise.) What are the underlying holdings? Are those underlying holdings based on something, like an index, or are they actively selected and managed? How does the total return (price appreciation + distribution) perform in bear, choppy, and bull markets? Do I honestly think the ETF can payout its promised yield during all types of markets without eroding the underlying asset value of the ETF? That last question is really important because a declining fund value will shrink the absolute dollar value of the distributions one receives over time.

Let's take these questions one by one. Funds write calls against a variety of ETF asset percentages. Some do 100%. Some 80%. Some less. Some are variable so they can adjust to market conditions. I personally prefer a fund with the flexibility to adjust to market conditions. When a super high portion of the NAV has calls written against it, the ETF loses in 2 ways. The first is it gives up more upside potential because the calls serve as a cap on the upside growth potential of the fund's stock holdings. The fund loses out on the upside price appreciation in a bull market and that lost price appreciation slows the ability for the fund to compound its distribution. All of us want a percentage of a higher number and not a smaller one. Funds that give away a large amount of price appreciation via more call writing to achieve a higher distribution yield aren't able to do that as much or as fast. I'd rather have a slightly smaller distribution today if it means I'm going to get a much bigger distribution tomorrow.

The second thing is how far out of the money the calls are written. I do not like writing the calls at the money to maximize yield. I'd much rather the fund balance the income generated from writing the premium with giving the underlying securities it holds some leeway to appreciate. The third thing is what are the underlying holdings of the ETF. An ETF with active holdings is concerning because I would need to know the track record of the person deciding on the stocks or indexes or other ETFs it holds. I'd need to do some homework on those holdings if I'm not familiar with them. I would then have to separately always track what is going on to make sure nothing weird happens. I do not want to keep up with all that stuff. I doubt other people want to either. I prefer the ETF track an index and have holdings in line with that index, so I don't have to concern myself with the trades the ETF managers are making. Tracking an index also means lower portfolio turnover, and therefore lower costs.

The fourth thing is how will the fund perform in bear, choppy, and bull markets. This is critically important to understand. There are 3 variables you need to consider: the total return of the fund, the distribution durability, and the direction of the fund over time. A fund with a trend line going downward over time is a red flag. The only OK reason for an ETF to go down is for the underlying value of the stocks it holds to decrease. Stocks go down from time to time and that's expected. A covered call ETF going down for any other reason is not OK. The biggest problem to be aware of is the fund's value dropping due to it needing to sell its underlying holdings to fulfill the high distribution it pays. You absolutely do not want that because you want the ETF to compound over time and payout a higher absolute dollar distribution in the future than it does today.

In bull markets, covered-call ETFs should have no problem funding their distributions from their investment operations, which includes dividends received from underlying holdings, the income received from selling calls, and the price appreciation of its underlying holdings. The downside to covered-call ETFs in bull markets is they won't fully capture the upside of the underlying shares held because the calls they are selling cap the gains they will have on the percentage of the portfolio they choose to write calls against.

In choppy, sideways markets, the covered-call ETFs will actually outperform their underlying indices/holdings. The reason is the option premium they receive from selling calls and the option contracts themselves expire worthless.

The big thing you should consider is how covered call ETFs perform in bear markets. You do not want a covered-call ETF selling its underlying stock holdings at a loss to fund its promised distribution. This significantly limits the compounding the fund can enjoy when the market recovers. And, you run the risk of having your capital returned to you below your cost basis and having to pay taxes on it. That is absolutely the worst case scenario. However, some asset managers are going on YouTube channels, acknowledging the risk, and making it sound like it's not that big of a deal. It definitely is. The problem with analyzing covered call funds' performance during downturns is there's a limited track record for most of the ETFs. A lot of them came out recently in the last 3 years or so, and haven't experienced a prolonged downturn. Of the funds that have, I would not be interested in buying them because most of them are issued by asset managers I am unfamiliar with. So, unfortunately, knowing how most of the funds I'd even be interested in investing in would perform in a prolonged downturn is kind of an open question. The answer to whether covered-call ETFs can pay out their promised distribution during bull, choppy, and bear markets is most likely, yes, and who knows.

Given all the covered-call ETFs I've evaluated, there are only two I would feel comfortable investing in. Their symbols are GPIQ and GPIX. They are covered call ETFs from Goldman Sachs. I like them for a lot of reasons. The first is their structure. They write calls against a variable portion of their stock portfolio. They have the ability to write calls against 25% to 75% of the underlying stocks they hold. This means in a bull market, they will write a smaller percentage of calls, which allows them to capture as much upside in the market as possible. In a downturn, they can increase the percentage of calls they write to service the distribution without having to dip into invested capital to do so. I don't know if this is 100% how they expect the fund to work in a downturn, but from reading the prospectus and some articles, that seems to be the case. I am reaching out to them to get more background on whether that is in fact the case and will relay what I find. This flexibility preserves the benefit of upside working to your benefit in a bull market without having to pay taxes on capital losses. I also like the yield percentages the ETFs are looking to hit. Roughly 10% for GPIQ, which has underlying stocks tracking the Nasdaq 100, and 8% for GPIX, whose underlyings track the S&P 500. Both sit in a sweet spot slightly above high dividend-paying companies and beneath the super high yield ETFs targeting 12% to 20% and much more. The fund managers are not picking stocks; they are simply tracking an index when it comes to the underlying stocks the ETFs hold. The asset manager, Goldman Sachs, is a blue chip name. I believe they are going to make good decisions reliably to payout the distribution at the yield they are targeting, while also balancing how to grow the total value of the ETF, so it can compound as much as possible over a long period of time. The expense ratio of the fund is 0.35%. This is significantly higher than the expense ratios of the largest index ETFs. However, for an actively managed fund this is reasonable. QQQ has a 0.18% expense ratio today. I think a lot of people would be willing to earn higher distributions for a 17 point increase in the expense ratio. The only catch with either of these funds is we don't know how they will fund their distributions during a prolonged downturn.

Both funds have only been around since 2023. The last prolonged downturn was in 2022. There are funds who have done it, but there isn't a history of it being done by GPIQ or GPIX. If you find yourself wishing your investments paid you a bit more, and you want to invest in covered-call ETFs because the yields look attractive, my recommendation is to start your research with GPIQ and GPIX.