The recent surge in the popularity of exchange-traded funds (ETFs) has spotlighted a particularly intriguing niche: options-based ETFs. These funds employ options—contracts that confer the right, but not the obligation, to buy or sell an asset at a predetermined price before a specified date—as a strategy to generate returns. Among these, covered-call ETFs have gained traction, especially in the wake of the protracted 2022 bear market. These specialized funds offer higher income yields, albeit at the cost of potential capital appreciation.
The mechanics of covered-call ETFs are straightforward yet sophisticated. At the core of this strategy is the concept of “buy-write,” wherein an investor owns 100 shares of a security and simultaneously sells a call option against those shares. The sale of the call option grants the buyer the right to purchase the shares at a set price, known as the “strike price.” The seller receives an upfront cash premium, determined largely by factors such as the proximity of the strike price to the current market value of the asset, the time until the option’s expiration, and the volatility of the underlying asset.
This dynamic means that while covered-call ETFs can provide a steady income stream—particularly beneficial in bearish or sideways markets—they also constrain the potential for gains during robust upward price movements. The allure of these funds lies in their capacity to balance income generation with risk management, making them an attractive option for conservative investors prioritizing yield over growth.
Investors interested in these options-based ETFs should carefully consider the variety of strategies employed within this space. Some funds focus on individual stocks, while others apply their strategies to wider indices like the S&P 500 or Nasdaq-100. The variety extends to the intricacies of expiration dates, with funds that trade options with just days to expiry alongside those taking a longer view. Moreover, variations in coverage ratios—from those that sell call options on 100% of their portfolio to others that do so selectively—offer additional layers of choice.
While the potential for income generation is appealing, covered-call ETFs are not without risks and complexities. They may not be ideal for all investors, particularly those who are less tolerant of the tax implications often associated with these investment vehicles. Covered calls can lead to a tax drag, as certain distributions may be taxed as ordinary income rather than capital gains, thereby impacting overall returns.
Given the diversity among options-based ETFs, a thorough analysis is critical for potential investors. By applying specific criteria, savvy investors can identify the most viable covered-call ETFs for their portfolios. Initially, a key consideration is the structure of the ETF; funds utilizing synthetic buy-write setups, which may carry higher counterparty risk, are typically avoided. In instances where only individual stocks are included, diversification could be lacking, limiting overall market exposure.
Subsequent evaluations focus on risk-adjusted returns relative to traditional index ETFs. Given that the primary trade-off in a covered-call strategy is an anticipated sacrifice of upside for income, funds that exhibit resilience during periods of market volatility should be prioritized. Additionally, management fees play an important role in attracting investor interest; ETFs are often scrutinized for expense ratios, with a benchmark of 0.7% established to maintain cost efficiency.
Among the leading candidates in this investment class is the JPMorgan Equity Premium Income ETF (JEPI), boasting $39.8 billion in assets under management and an expense ratio of 0.35%. This ETF focuses on a collection of defensive, low-volatility U.S. equities combined with S&P 500 call options via equity-linked notes (ELNs). This structure offers potential exposure to index-level option premiums while stemming from a more stable stock base.
A further notable entry is the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ), which mirrors the Nasdaq-100 and leans toward high-growth sectors, particularly the “Magnificent Seven” tech stocks. With a dividend yield of 11.4%, JEPQ leverages the greater income potential associated with the volatility of its underlying assets.
For those seeking higher returns, the NEOS S&P 500 High Income ETF (SPYI) represents another significant option. This fund entirely replicates the S&P 500 by holding stocks within the index, and it sells call options on the S&P 500 index mark to capitalize on premium opportunities. SPYI also offers enhanced tax benefits, as its options are classified as Section 1256 contracts, which results in a tax-efficient blended rate for capital gains.
On a similar note, the NEOS Nasdaq 100 High Income ETF (QQQI) embodies the strategy of SPYI, with an emphasis on Nasdaq-100 stocks and a notably higher income yield due to the volatility of its underlying assets.
In the world of actively managed covered-call ETFs, the Amplify CWP Enhanced Dividend Income ETF (DIVO) stands out as a highly rated fund amongst large-cap value peers. With a portfolio concentrated on approximately 20 to 25 blue-chip stocks, DIVO’s management employs tactical call writing based on fundamentals such as earnings growth and cash flow. Although its yield sits at 4.8%, historical performance has demonstrated robust total returns, underscoring the value of rigorous stock selection and strategic option selling.
That said, engaging with covered-call ETFs requires investors to remain aware of market dynamics and how these products function. The flexibility presented by various strategies allows for customization based on an investor’s income preferences and risk tolerance. However, while they can be attractive for income-focused strategies, they should not be seen as a one-size-fits-all solution.
By carefully weighing both the advantages and limitations of covered-call ETFs, investors can strategically enhance their portfolios in a way that meets their financial goals. As with any investment, due diligence, comprehensive research, and a keen understanding of the underlying mechanisms are essential steps in the journey toward successful investing. As the financial landscape evolves, particularly in reaction to macroeconomic variables, the prospects for options-based strategies will likely continue to expand, reflecting both investor interest and market innovation.