Covered-call ETFs can offer enhanced yields… but there’s a catch

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The rapid growth of covered-call ETFs is a global trend driven by investors who are seeking higher income in a volatile market environment, says Shane Murphy, senior portfolio manager at Irish Life Investment Management.

He said global AUM in covered-call strategies was pegged at US$84 billion last year. And with stocks pricier than normal, he expects that number to continue to climb.

“History suggests that long term equity upside is more limited when equities are very expensive,” he said. “We currently have the S&P trading at a multiple of 22.5x earnings. That’s six points higher than its long-term average. So, it may not be such a bad strategy to sell away some of that potential upside in exchange for a steady income stream at those sorts of valuation.”

Speaking on the Soundbites podcast this week, Murphy said covered-call ETFs can offer enhanced yields by generating option-premium income — something that is especially attractive to income-focused investors and those in retirement.

In the current moment, equity markets are uncertain and traditional fixed-income yields are relatively modest, he said.

“Investors are looking for ways to boost cash flow without taking on excessive credit risk. And covered-call strategies do fit that need,” he said, adding that a covered-call strategy can generate around 5% to 6% income yield, and still retain some upside exposure to equities.

“It’s for someone who isn’t worried about missing out on very high returns when they materialize but is happy to earn that 5% or 6% income every year,” he said. “If you’re happy with that, this is a very good strategy for you.”

For more growth-oriented investors, a smaller allocation can provide diversification and help smooth returns during periods of market volatility.

“But the key trade-off [that] you have to bear in mind is that they offer limited participation,” he said. “So, if markets rally really strongly, returns are going to lag those of a pure equity fund. This creates that asymmetrical risk-return profile. You’re giving up some potential gains in exchange for more consistent income and some downside protection.”

He said in sharply rising markets, that opportunity cost can be significant.

“Covered-call strategies are going to perform best in sideways or moderately rising markets, where the option premiums collected are really added on to the returns that the index generates, and there’s less risk of missing out on large gains,” he said.

“They can also provide some cushion in mildly declining markets. But in really strong bull markets, the strategy is going to underperform due to the capped upside.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.