Covered Call ETFs: High Yields, Hidden Risks

As exchange-traded funds (ETFs) that use covered call strategies become more popular with retail investors, financial experts warn these vehicles involve clear trade-offs. Supporters say covered call ETFs can be a useful tool for investors focused on income, while critics caution they may reduce long-term growth and are not appropriate as a core holding for most portfolios.

Prerna Mathews, vice-president of ETF product strategy at Mackenzie Investments, explains that covered call ETFs generally hold dividend-paying stocks and enhance income by selling call options on those positions. A call option gives the buyer the right to purchase the underlying security at a predetermined price. In return for the option premium, the ETF limits its upside once the option strike is reached, effectively “trading” some future capital appreciation for current income.

Mathews notes these ETFs have seen rapid growth recently, driven by investor appetite for higher yield. They can be appealing to those who prioritize steady income and lower short-term volatility over maximum capital appreciation.

“There’s definitely a trade-off; there’s no free lunch. The higher yield off the options premiums is coming off of the fact that you are giving up long-term return in the stock,” Mathews said. “Those options premiums, you’re getting paid out on them today, but that total return impact is usually much more significant than the yield that you’re actually generating off of them.”

She adds that investors need to do their homework rather than being swayed by an eye-catching yield figure or marketing materials.

Covered call ETFs offer income — but at a cost

Fred Masters, president of Masters Money Management Inc., recommends thinking of covered call ETFs as “enhanced income” products. They use options to boost distributions, but that comes with higher management fees and often lower long-term returns compared with straightforward equity ETFs. Masters cautions investors not to build the bulk of a portfolio around these products, although they can serve a tactical or complementary role within a diversified plan.

He points out that the management fees on covered call ETFs can be substantially higher than on plain-vanilla ETFs in the same asset class.

“You can’t control outcomes in many cases when investing in equity markets, but you can control costs and keeping costs to a minimum year after year is a crucial tenet of long-term investing success,” he said. “We know these covered call ETFs are expensive and that eats into returns annually.”

When covered call ETFs may perform well — and when they may lag

Nick Hearne, a financial adviser and portfolio manager at RGF Integrated Wealth Management, explains that covered call ETFs tend to do best in range-bound or mildly declining markets. In those environments, the additional income from option premiums can offset modest market weakness and produce better relative performance than a long-only strategy.

“Where they’re going to underperform is when the market increases significantly over a period of time … what they’re really doing is when they sell those call options, they’re selling their upside. That’s the downside,” Hearne said. “And over the long term, (covered call ETF investors) have less exposure to the market because they are selling part of their exposure, and so the expectation would be that a long-only or traditional strategy would outperform a covered call strategy.”

Why retirees and income seekers are drawn to covered call ETFs

Mathews says these ETFs can be attractive to retirees and other investors who need reliable distributions and have a lower tolerance for portfolio volatility. With yields on traditional fixed-income instruments lower than in past decades, some income-seeking investors look to dividend-paying equities paired with option-writing to boost cash flow.

However, she cautions that covered call exposure brings equity market risk that differs from fixed income. Investors must weigh the higher income against the possibility of missing out on market rallies and the higher fees associated with these strategies.

Despite those trade-offs, covered call ETFs have gathered significant assets. Mathews notes multiple providers now offer covered call products in Canada, with substantial allocations to these funds as investor demand continues, particularly among older demographics seeking income solutions.

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