Investors spend significant time and effort searching for income in their portfolios. Derivative enhanced ETFs like Covered Call ETFs can provide unique opportunities for the income investor. In the following article, Vernon Roberts, CFA, MBA, Head of Covered Call ETFs at Horizons ETFs, speaks about the key features and benefits of Covered Call ETFs and their ability to generate income.

What is a Covered Call ETF?

A Covered Call ETF is an investment fund that combines two primary strategies: owning a portfolio of assets, such as stocks or bonds, and simultaneously selling call options on those assets. The term “covered” in covered call refers to the fact that the call options sold are covered by the ownership of the underlying assets. This strategy is designed to generate income for investors while providing some downside protection.

The first Covered Call ETF was launched in the United States on December 5, 2007. It provided investors with exposure to the S&P 500 Index while implementing a covered call strategy on a portion of the portfolio.

Since their introduction, covered call ETFs have expanded to include a wide range of asset classes, sectors, and geographic regions. Investors have gained access to covered call strategies on equities, fixed income, and commodities. These ETFs have grown in popularity due to their ability to provide regular income while offering a degree of downside protection via the use of call options. 

As of August 31, 2023, the Canadian Covered Call ETF market has grown to nearly CAD $20 billion. Figure 1 below highlights the assets under management (AUM) and fund flow growth since September 2021

What are the key benefits of owning Covered Call ETFs?

While most investors choose Covered Call ETFs for income generation, there
are several benefits these funds offer to investors. Some of the benefits investors may receive when owning Covered Call ETFs include:

1. Income Generation: Covered Call ETFs primarily generate income by selling call options on the underlying assets held within the fund. This can provide investors with a regular stream of income, making the funds attractive for income-oriented investors. 
2. Downside Protection: The premium received from selling call options can provide a cushion against potential losses in the underlying assets. This downside protection can help mitigate losses during market downturns. 
3. Enhanced Total Return: Receiving income from the sale of call options can potentially enhance the total return of a Covered Call ETF. This is particularly beneficial in down and sideways markets. 
4. Portfolio Diversification: Covered Call ETFs typically hold a diversified portfolio of stocks or other assets, which may help spread risk across an index or sector. This diversification can be appealing to investors looking to reduce single-stock risk. 
5. Professional Management: Covered Call ETFs are managed by professionals who actively select and manage the covered call options. This can save investors the time and effort required to manage an option portfolio. 
6. Liquidity: Most Covered Call ETFs are traded on major stock exchanges, providing investors with liquidity and the ability to buy and sell shares throughout the trading day. 
7. Tax Efficiency: Covered call strategies may result in tax advantages, as the income generated from options premiums is taxed as capital gains. Consult a tax professional for specific tax implications. 

What are the drawbacks of owning Covered Call ETFs?

Despite the benefits listed above, there are several downsides and risks that investors should be aware of. They include:

1. Bull Markets: Covered call strategies are often more effective in sideways or bearish markets, where the income generated from selling call options can help offset potential losses in the underlying assets. In strong bull markets, the strategy may result in underperformance compared to traditional equity investments. 
2. Complexity: Covered call strategies can be complex, especially for inexperienced investors. Understanding the mechanics of options, strike prices, and expiration dates may be challenging. 
3. Tracking Error: Covered Call ETFs may not perfectly track the performance of the benchmark index. This tracking error may result in returns that deviate from investor expectations. 
4. Income Fluctuations: While Covered Call ETFs are designed to generate income, the amount of income can vary depending on market conditions. Covered Call ETF income may fluctuate more than dividends from traditional dividend-focused ETFs or stocks. 
5. Tax Considerations: The income generated from covered call strategies may be taxed differently from dividends or long-term capital gains. Investors should consult with a tax professional to understand the specific tax implications. 

While Covered Call ETF may outperform in bear markets, the downsides of owning a covered call ETF are primarily related to the trade-offs between income generation and potential capital gains.

How does one capture the upside with covered calls?

One major objection that investors make regarding Covered Call ETFs is the perceived cap in the upside potential during a bull market. While this may be true in some cases, this view does not tell the entire story.

The “Capped Upside” view comes from the way most textbooks teach the
covered call strategy. In these lessons, each component is looked at in isolation and then combined to create the standard covered call profit and loss chart you
see in Figure 2 in grey. The nuance that most people miss is that the base
assumption in the textbook example is that the portfolio sells a call option for
the same quantity of shares that is owned. In other words, the option position 100 percent covers the stock position.

In practice, covered call ETFs implement different strategies when it comes to the percentage of options they sell. Typically, Covered Call ETFs option positions represent between 25 and 100 percent of the underlying portfolio. Figure 2 highlights how a 50 percent covered call ETF (dark blue line) participates in the upside and more closely mimics a long stock position (orange line) during a bull market.

The impact of changing the written percentage is two-fold. As the portfolio manager writes fewer options the portfolio participates more in bull markets; however, the option strategy generates less income. Conversely if the portfolio manager sells more options, the portfolio generates more income but participates less in bull markets. Figure 3 below highlights the performance difference between a 100 percent call writing and a 50 percent call writing for the CBOE S&P 500 BuyWrite and CBOE S&P Half BuyWrite indexes respectively. 

What are the investment opportunities in covered calls?

 The Covered Call ETF space has seen ongoing innovations aimed at enhancing performance, efficiency, and customization for investors. Some of the investment opportunities that have taken place in this industry include:

1. Active Management: While many Covered Call ETFs follow passive strategies, some providers are introducing active strategies. These actively managed ETFs allow portfolio managers to make real-time decisions and provide more dynamic and adaptive strategies that respond to market conditions. 
2. Global Expansion: Covered Call ETFs are being launched in various global markets, providing investors with exposure to income-generating strategies in international and regional markets.
3. Asset Allocation: Some Covered Call ETFs combine the income generation benefits of covered calls with the convenience of asset allocation ETFs. These ETFs aim to provide a one-ticket diversified solution for investors.
4. Sector-Specific Strategies: Some Covered Call ETFs focus on specific sectors or industries, such as technology, healthcare, or financials. By concentrating on a particular sector, investors can benefit from income generation while focusing their exposure to specific sectors.
5. Asset Class Diversification: Some ETFs are applying covered call strategies beyond equities to other asset classes, including fixed income and commodities. This allows investors to broaden the scope of income-generating opportunities and diversify their income streams across various asset types.
6. Leveraged/Enhanced Covered Call ETFs: These are specialized funds that incorporate both the features of covered call strategies and leverage. These ETFs aim to amplify returns or provide a hedge against market movements using covered call strategies and various option positions to manage risk.

It’s important for investors to carefully research and assess the specific strategies offered by each covered call ETF as they vary among providers and may have different risk-return profiles. Investors interested in covered call ETF strategies should carefully review the fund’s objectives, holdings, fees, and historical performance and align the strategy with their specific investment goals and risk tolerance.

Disclaimer

This communication is intended for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase exchange traded products (the “Horizons Exchange Traded Products”) managed by Horizons ETFs Management (Canada) Inc. and is not, and should not be construed as, investment, tax, legal or accounting advice, and should not be relied upon in that regard. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Investors should consult their professional advisors prior to implementing any changes to their investment strategies. These investments may not be suitable to the circumstances of an investor.

Certain statements may constitute a forward-looking statement, including those identified by the expression “expect” and similar expressions (including grammatical variations thereof). The forward-looking statements are not historical facts but reflect the author’s current expectations regarding future results or events. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from current expectations. These and other factors should be considered carefully and readers should not place undue reliance on such forward-looking statements. These forward-looking statements are made as of the date hereof and the authors do not undertake to update any forward-looking statement that is contained herein, whether as a result of new information, future events or otherwise, unless required by applicable law.

The views/opinions expressed herein are solely those of the author(s) and may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are generally based on information available as of the date of publication and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.