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

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Welcome to Soundbites, weekly insights on market trends and investment strategies, brought to you by Investment Executive and powered by Canada Life. For today’s Soundbites, we’re talking about covered-call strategies with Shane Murphy, senior portfolio manager with Irish Life Investment Managers. We talked about how and where to use them, benefits and risks, and we started by asking about their recent popularity.

Shane Murphy (SM): The rapid growth of covered-call ETFs in Canada is part of a broader global trend. But Canada has been a clear leader in this space. We’re seeing increased interest in these covered-call strategies in the U.S., Europe, and parts of Asia as well, with new products launching and assets under management rising all the time. A report last year put global AUM at US$84 billion, and there are now 33 different ETF providers with over US$200 million each under management. Their appeal is largely due to the search for higher income in a volatile market environment. Covered-call ETFs can offer enhanced yields by generating option-premium income, which is especially attractive when equity markets are uncertain and traditional fixed-income yields are relatively modest. So, if we look at bond yields, they are currently higher than they were certainly in the early part of the decade, but still not high enough to make the sorts of returns a covered-call strategy can generate, unless the investor takes on a lot of default or credit risk. The Canadian 10-year yield is trading at 3.5% and the average investment-grade credit spread is at a very tight level, currently around 75 basis points. So getting to that 5% or 6% number is difficult. What the covered-call strategy can do is it has the ability to generate around 5% to 6% income yield and still retain some upside exposure to equities. And that has helped them to deliver strong historic returns, close to keeping pace with those underlying equity assets and beating a lot of other income-focused strategies using traditional credit and bonds.

How they’re designed to work

SM: A covered-call strategy involves holding some sort of risky asset and then selling call options on that same asset. So as the underlying asset, we’re going to hold an equity index ETF, and then we’re going to sell call options on that equity index ETF. The investor collects option premia, which provide additional income on top of any dividends. And the premium can then be distributed to investors, supporting regular cash flow needs. So you can get the money every month, or every quarter or every year, or you can have it reinvested back into the product. For those with a strong income focus, these can really be a core part of their allocation, replacing or complementing traditional dividend-focused funds or even fixed income and credit allocations to diversify your income sources. For more growth-oriented investors, a smaller allocation can provide diversification and help smooth returns during periods of market volatility. It’s important to consider the overall risk profile of the investor and ensure that the use of covered-call strategies aligns with their needs for income, risk tolerance, and their long-term objectives.

Benefits and risks

SM: The main benefit of these strategies is enhanced income. So, covered calls can deliver higher yields than traditional equity funds. So, if we take the Canadian TSX 60 index, it has a dividend yield of 2.8%. MSCI EAFE index, which is our international index, that has a dividend of just below 3%. And for the S&P 500, it’s even lower. The 12-month dividend yield on the S&P is just 1.2%, pretty much as low as it has ever been historically. So, call writing or covered calls serve to boost this income to get it closer to a 5% target level that these funds are looking to generate. They also tend to reduce portfolio volatility, and the option premiums provide a buffer against modest market declines. But the key trade-off that you have to bear in mind is that they offer limited participation. So, if markets rally really strongly, returns are going to lag those of a pure equity fund. So, this creates that asymmetrical risk-return profile. You’re giving up some potential gains in exchange for more consistent income and some downside protection. So, in sharply rising markets, that opportunity cost can be significant.

Suitable markets

SM: 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. 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. And in sharply falling markets, while the option premium helps to offset those losses, the strategy still carries equity risk and does not provide full downside protection.

And finally, what’s the bottom line on covered-call strategies?

SM: Covered-call strategies are a valuable tool for generating income and reducing volatility but it’s important that clients understand the trade-offs. Higher income comes at the cost of limited upside. So these strategies will work best for investors who prioritize cash flow and are comfortable with the possibility of lagging in bull markets. But, look, I’ll leave you with one final thought. History suggests that long-term equity upside is more limited when equities are very expensive. And we currently have the S&P 500 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.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Shane Murphy of Irish Life Investment Managers. Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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