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With 10-year Treasury yields hovering around 4.35% as of June 18 and murkiness surrounding exactly when and to what extent the Federal Reserve will cut interest rates, many investors are rightfully pensive about bonds.
Those jitters are confirmed by the Bloomberg U.S. Aggregate Bond Index being down 1.34% on a year-to-date basis. Still, many investors need and want income and with many of the highest-flying stocks being nominal dividend payers, if they even have payouts, investors are finding the current income environment to be somewhat challenging.
In large part, the above scenarios explain the proliferation and popularity of covered-call exchange traded funds. These ETFs have rapidly become fan favorites, with some of those fans being advisors, in recent years because the products have high yields and essentially no interest rate risk.
Consider the case of the JPMorgan Equity Premium Income ETF (JEPI), one of the largest products in this category. JEPI, which sports a 30-day SEC yield of 7.55%, is just 49 months old and already has $33.48 billion in assets under management. JEPI isn’t alone in its popularity as more than a dozen ETFs in this category have more than $1 billion in assets. Of course, advisors know that popularity and “appropriate for all clients” are distinct phenomenon. Let’s examine some of the pros and cons covered-call ETFs.
With Covered-Call ETFs, Timing Matters
It’s often said that market timing is exceptionally difficult and it is. Advisors shouldn’t bother with it, but therein lies some of the rub with covered-call ETFs: timing matters.
“Generally, covered-call funds have performed well in flat to modestly bullish markets. If the option expires without being exercised, the seller keeps the stock and the premium received,” notes Emily Doak of Charles Schwab. “As a result, covered-call funds often report higher-than-average yields due to selling options and delivering the premiums along with dividends earned on stocks to investors. However, when an investment promises more income, it generally delivers lower capital appreciation.”
However, covered-call ETFs are prime examples of there being no free lunches in investing. By accessing the benefits of downside protection and high yields – an attractive combination – investors sacrifice upside potential. Translation: a strong-trending bull market means investors will leave returns on the table with covered-call ETFs.
Obviously, lost upside isn’t desirable and as it pertains to covered-call ETFs, that specter implies traditional dividend stocks or ETFs could be suitable for wider swath of clients.
“Over longer time periods, the impact of missing the upside can be seen clearly. From 2013 to 2023, the Dow Jones U.S. Dividend 100 index significantly outperformed the S&P 500 Dividend Aristocrats Dynamic Coverage Covered Call index,” adds Doak.
Mind Tax Implications
Advisors know as much, but many investors do not: the dividends generated by covered-call strategies are subject to different tax treatment than the payouts on individual stocks or dividend funds. That means there are some tax implications regarding covered-call ETFs that must be acknowledged when these funds are held outside of tax-advantaged accounts.
Put simply, covered-call funds typically lob off ordinary income, which is taxed at significantly higher rates than are qualified dividends. Clients and investors need to acknowledge that point before jumping in.
“From a tax-efficiency standpoint, an ETF that generates significant income from covered calls will generally produce a larger tax drag on returns, especially for those in higher tax brackets,” concludes Doak.
Related: A Fresh Spin on Old Small-Cap ETFs