Previously, I had introduced the concept of options, explored their use in generating passive income and the possibility for passive investors to engage in options trading.
In this post, we are going to talk about the latter.
And understanding the passive investing methodology, we shall let exchange traded funds (ETFs) to do the job, namely covered call ETFs.
Sidetrack: What Is A Covered Call?
Covered call is an option strategy in which an investor writes (or sells) call options on the equivalent number of underlying securities that he/she owns.
The main aim of an investor doing a covered call is to generate passive income. As explained in my post on options here, the passive income comes in the form of premiums received. Ideally, an investor could earn passive income indefinitely by writing a new call option after the previous one expired, and repeat the process, hoping they were not exercised at all. However, when the options do get exercised, the investor would need to sell his/her securities at a lower-than-market price and may need to acquire new securities to carry on the cycle. Thus, the covered call strategy typically works well on securities that do not see much price movement, especially upwards.
The main disadvantage of a covered call is the limited “upside” or having less profit. By “locking” a selling price of the securities (the strike price), the opportunity cost would be the actual profit to be made from them, at the expense of getting the premium. For example, an investor initially bought 100 shares of X at $100 each and wrote a call option with a strike price of $120 at a premium of $5 per share (total $500). If X’s share price went up to $150, the call option buyer would exercise the option, and for the investor, instead of making ($150-$100) x 100 = $5000 by selling X on the open market, he/she only made [($120-$100) x 100] + $500 = $2500.
The Covered Call ETFs
There are ETFs listed in the United States (U.S.) doing covered calls, and they are a popular form of passive income instrument for U.S. based investors as some of them do monthly distributions for dividends. Here are some of the well-known ones:
- Global X Nasdaq 100 Covered Call ETF (QYLD)
- Global X S&P 500 Covered Call ETF (XYLD)
- Global X Russell 2000 Covered Call ETF (RYLD)
- Global X Nasdaq 100 Covered Call & Growth ETF (QYLG)
- Global X S&P 500 Covered Call & Growth ETF (XYLG)
- Amplify CWP Enhanced Dividend Income ETF (DIVO)
- JP Morgan Equity Premium Income ETF (JEPI)
- Nationwide Nasdaq-100 Risk Managed Income ETF (NUSI)
|Counter||Date of Inception||Asset under management (AUM) (US$)||Expense Ratio||Dividend Yield||Distribution Frequency||Underlying Index||Options Strategy|
|QYLD||11-Dec-13||7.12B||0.60%||11.27%||Monthly||CBOE Nasdaq-100 BuyWrite V2 Index||Covered Call|
|XYLD||21-Jun-13||1.38B||0.60%||9.12%||Monthly||CBOE S&P 500 BuyWrite Index||Covered Call|
|RYLD||17-Apr-19||1.27B||0.70%/0.60%||11.34%||Monthly||CBOE Russell 2000 BuyWrite Index||Covered Call|
|QYLG||18-Sept-20||60.85M||0.60%||5.29%||Monthly||CBOE NASDAQ-100 Half BuyWrite V2 Index||Covered Call on 50% of portfolio|
|XYLG||18-Sept-20||44.56M||0.60%||4.26%||Monthly||CBOE S&P 500 Half BuyWrite Index||Covered Call on 50% of portfolio|
|DIVO||14-Dec-16||1.36B||0.55%||4.92%||Monthly||None. Actively managed in terms of stock selection from S&P 500 counters||Covered Call|
|JEPI||20-May-20||7.82B||0.35%||7.95%||Monthly||None. Actively managed in terms of stock selection from S&P 500 counters||Covered Call|
|NUSI||19-Dec-19||839.9M||0.68%||7.56%||Monthly||CBOE S&P 500 Zero-Cost Put Spread Collar Index||Protective Collar (Covered Call + Protective Put)|
Fig.1: List of covered call ETFs. Information based on their respective factsheets as of 31 Mar 2022. Dividend yield data from ETFDB.com as of 2 May 2022. DIVO AUM data from ETFDB.com as of 2 May 2022.
From Figure 1, you could see the attractiveness of such ETFs based on their dividend yield and distribution frequency, especially RYLD, QYLD and XYLD (which ironically, they are from the same ETF provider, Global X). Given the high dividend yield, and the mentality of “there ain’t no such thing as a free lunch” in the financial markets, what gives?
Taking QYLD and XYLD as a basis since they were incorporated almost a decade ago, their share price since inception until 2 May 2022 were from around US$25 to US$19.60, and around US$40 to US$46.89, respectively. This meant that QYLD had lost about 21.6% and XYLD had gained only 17.23% of their respective share prices. Compare them to the actual Nasdaq 100 (using QQQ) and S&P 500 (using SPY) indices which for the same period, returned around 261% and 159% respectively. Factoring in reinvestment of dividends and using compound annual growth rate (CAGR), QYLD : QQQ is 7.2% : 17.5% and XYLD : SPY is 6.95% : 12.15%1.
This brought us back to the characteristic of covered calls as explained in the section above: limited upside. These ETFs do not really cater for growth, but rather concentrate on the passive income part of it (i.e., premiums from writing of options).
There are some steps taken by the ETF providers in having a balance between growth and income for such ETFs, as seen from Figure 1. Two examples are QYLG and XYLG, in which 50% of the holdings are subjected to covered calls as opposed to the whole thing, at the compromise of much lower dividend yield. Others like JEPI and DIVO adopted an active management approach with respect to having growth and tactically employ covered calls.
For Singaporean investors who are non-U.S. residents, the dividends are subjected to a 30% withholding tax, so the actual dividend yield would be 30% off the displayed number (e.g., RYLD’s 11.34% would be net down to 7.94%). This is a very big haircut, but that is the package that comes along with receiving dividends from the U.S. markets. Another factor to take note would be forex risk since the underlying assets are priced in US$.
While these ETFs do not really perform as well as their underlying indices, the main plus point is the higher dividend yield (e.g., QYLD’s 11.27% versus QQQ’s 0.45%, XYLD’s 9.12% versus SPY’s 1.22%)2, and this enables a better cash flow from the securities without the need of liquidating them. This cash flow could be used to provide passive income and/or to fund other investments. It is still worth if the dividend part exceeds the loss of the capital overall.
The Final Question: Should I Go For A Covered Call ETF?
Having said much about covered call ETFs, it boils down to this basic question: should I be going for such ETFs? The answer is, as usual, it depends.
If you are not comfortable with having them, and/or trying to make your investment portfolio as simple as possible, then just leave them out. However, if you wish to include them, do make sure of the aims and considerations stated in the previous sections. As covered call ETFs are a form of derivatives, such securities would be outside of your normal investment portfolio and instead, be placed in a trading one (see here). Still, it is up to you on what to do with the dividends: you may continue to park them in the trading portfolio, or transfer some/all of them to feed your investment portfolio.
May The Fourth be with you.
The Bedokian is invested in RYLD.
1 – Period of Jan 2014 to Apr 2022. CAGR numbers are before inflation. Portfolio Visualizer. www.portfoliovisualizer.com. 3 May 2022.
2 – ETF Database. www.etfdb.com. 2 May 2022.