Covered Call ETFs: What They Are and When to Invest

Covered-call exchange-traded funds (ETFs) have attracted growing interest from Canadian investors looking for higher income, says Travis Koivula, an investment advisor with Aviso Wealth in Victoria. As more retail investors manage their own accounts, many are drawn to the steady distributions these funds advertise. However, covered-call ETFs come with trade-offs that Canadian investors should understand before allocating capital to them.

First, what is a covered call, anyway?

A call option gives a buyer the right to purchase a stock at a specified price within a set time frame. The seller of that option receives a premium for granting this right. When the seller actually owns the underlying shares, the option is called “covered.” Canadian investors who own shares can “write” (sell) a covered call to generate income and reduce some downside risk. For background, see this overview of call options.

One well-known historical example involves Mark Cuban after he sold Broadcast.com to Yahoo! in 1999 and received millions of Yahoo shares. Because he was restricted from selling immediately, he implemented an approach like writing covered calls to earn income while holding the position, explains Koivula.

To illustrate, assume Cuban owned Yahoo shares trading at $95 and sold a covered call with a $100 strike for a $4 premium. Two simple outcomes follow:

Scenario 1: If the stock rises to $110, the option buyer exercises the call and Cuban must sell at $100. He keeps the $4 premium but forgoes the additional upside; his effective proceeds are $104 instead of the $110 he would have gotten by holding without writing the call.
Scenario 2: If the stock falls to $90, the option expires unexercised. Cuban suffers a $5 decline in the stock’s value but offsets most of that loss with the $4 premium, finishing at $94 instead of $90.

In other words, covered calls dampen both upside and downside while providing immediate income from premiums.

What are covered call ETFs?

Most individual investors do not actively trade options, but they can access covered-call strategies through ETFs. Covered-call ETF managers write options on a portfolio of stocks on behalf of fundholders, collecting premiums and distributing income. Examples include Global X’s S&P 500 Covered Call ETF (XYLD), and in Canada, funds such as RBC’s Canadian Dividend Covered Call ETF (RCDC) and CI’s Gold+ Giants Covered Call ETF (CGXF). Use a Canadian ETF screener to compare options and yield profiles.

Why are covered call ETFs gaining traction?

Many Canadian retail investors search for ETFs with the highest dividend or yield. Covered-call ETFs often appear near the top of those searches because they distribute option premium income in addition to any dividends from the underlying holdings. For example, as of Feb. 14, 2024, XYLD reported a trailing 12‑month yield of 10.6%, which can be compelling on the surface.

For investors who expect markets to remain flat or decline somewhat, covered-call ETFs can seem attractive: they provide a regular income stream and can make holding a position feel productive when capital appreciation is limited. Koivula notes that many clients like the mentality of “getting paid to wait” in such market conditions.

Are covered call ETFs a good investment?

While covered-call ETFs often pay high distribution yields, they are not universally appropriate. There are several important drawbacks to consider before investing.

1. Covered call ETFs are an underperforming long-term strategy

High distribution yield is not the same as superior total return. Covered-call strategies sell away some or all of the upside of the underlying holdings. Over long periods, equity markets tend to trend upward, so repeatedly giving up upside can meaningfully reduce long-term returns.

Returning to the earlier example: if Yahoo rose to $150, Cuban would miss out on substantial appreciation while only receiving the modest $4 premium. The net effect can be negative if the stock’s long-term gains far exceed the periodic premiums collected. That trade-off helps explain why some covered-call ETFs lag broad index ETFs over multi-year time horizons. For example, XYLD, which writes calls on the S&P 500, has materially underperformed a plain S&P 500 ETF such as VOO over several years, with the gap widening on longer horizons.

_{XYLD vs. VOO five-year performance (as of Feb. 15, 2024). Source: Morningstar}

2. Higher fees compared to passive ETFs

Most plain-index ETFs are passively managed and have very low expense ratios. Covered-call ETFs are generally actively managed because implementing option-writing strategies requires ongoing trade decisions and execution. That active management typically comes with higher fees — for example, a vanilla S&P 500 ETF might charge 0.03% while a covered-call ETF could charge 0.60% or more. Higher fees compound over time and can further erode long-term returns.

3. Less tax efficient due to taxable distributions

Some Canadian investors assume covered-call ETF payouts are simple dividend income, but distributions often include a mix of dividends, capital gains and return of capital. Option premium income is generally recognized as capital gains when earned, and frequent option exercise and rebalancing can trigger realized gains within the fund. In contrast, a buy-and-hold index position typically defers capital gains until you sell. For taxable accounts, covered-call ETFs can therefore be less tax-efficient than a passive ETF held long term.

Covered call ETFs aren’t for everyone

Canadian investors should understand the strategy, tax implications, fee structure and expected performance profile before investing in covered-call ETFs. These funds can be useful for active or sophisticated investors who want to earn income in a flat or declining market over shorter time horizons. Given their tax and distribution characteristics, they are often better suited to registered, tax-advantaged accounts such as a registered retirement savings plan (RRSP), tax-free savings account (TFSA) or first-home savings account (FHSA) rather than a fully taxable account. For more on registered account choices, see guidance on the RRSP, TFSA and FHSA.

“Covered calls are a great way to earn income in a flat market or down market,” Koivula says. “But for long-term investors, owning the underlying index is often a more profitable and tax-efficient strategy.”

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