The TRUTH About Covered Call ETFs (QYLD, JEPI, etc.) - Watch Before Buying
Covered call ETFs own stocks, typically from some underlying index, and sell call options on them to generate income. Here I'll explain why they're probably not great investments for most investors.
// SUMMARY:
A covered call ETF may be suitable for your portfolio if you desire a yield-focused strategy for current income, with the trade-offs being greater fees (the average covered call ETF expense ratio is 0.71%), muted long term total returns, less diversification, lower portfolio efficiency, and possibly greater tax costs. Because of these things, recognize that it inarguably makes little sense for the young accumulator with a long time horizon to own a covered call ETF.
Novice investors seem to have this idea that the “income” from these expensive buy-write funds are free money and that selling shares of a low-cost index fund like VTI to realize gains of an equal amount is somehow inferior to receiving a monthly distribution. Neither of these things is true.
This irrational preference of dividends as income is just a well-documented – and admittedly understandable – mental accounting fallacy. Removing that high yield, the capital appreciation component of some of these funds has actually been negative since inception, as is the case for QYLD.
The promises and benefits touted by these funds and their supporters – such as greater Sharpe ratios – often don't hold water under the smallest amount of scrutiny, such as their objective inability to outperform the underlying index of their holdings even on a risk-adjusted basis, much less a better diversified portfolio across asset classes like a 60/40. Basically, in market downturns, a covered call fund will fall with the market by an amount precisely equal to the market's drawdown minus the income received from the option premium.
Don't succumb to mental accounting bias; the premium received doesn't mean much if the market crashes. At the end of the day, total return is what matters. Period. I suspect income investors who own these funds perhaps simply aren't being honest with themselves by selectively ignoring their long term total returns compared to a benchmark like the S&P 500 or 60/40 and instead are just focusing on that juicy monthly yield. Discussing and celebrating that yield, such as in dividend-focused communities on Reddit, usually just seem to be a clique of confirmation bias.
To be fair, covered call funds certainly aren't the worst way I've seen to try to generate income. So some small allocation to a covered call fund may be warranted for the income investor or retiree.
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