Covered call ETFs: A deeper dive

To explore covered call exchange traded funds (ETFs), including benefits, risks and implementation issues, we chatted with Greg Gipson, Managing Director of ETFs at CIBC Global Asset Management.

Covered call ETFs have gained popularity in recent years due to their ability to address several key investor needs in a changing market environment: a combination of growth and income. With higher variability in interest rates, traditional fixed income investments have offered limited yields, prompting investors to seek alternative sources of regular income. Covered call ETFs provide this by combining dividends from equities with option premium income, resulting in often higher but more consistent cash flow.

Another advantage of these ETFs is the potential for reduced portfolio volatility, appealing to risk-averse investors who want equity exposure but with less downside risk. The professional management offered by ETFs makes the complex process of options writing accessible to a broader investor base, removing the need for individual expertise in options trading.

Product innovation has also played a role, with the evolution from passive to actively managed covered call ETFs, and the introduction of sector-specific and international options, enabling additional diversification and customization. Improved transparency, reporting and educational resources have made it easier for investors to understand and monitor these strategies.

Finally, in periods of heightened market volatility, covered call ETFs can become even more attractive, as the income from the options overlay tends to increase. All these factors combined have driven their rapid adoption among income-focused and risk-conscious investors.

Covered call ETFs can offer attractive income and risk mitigation, but there are some risks that investors may not fully appreciate. One is the drag on performance from the options overlay: by selling call options, the fund gives up gains above the strike price if the underlying stocks rise sharply. Covered call strategies may underperform pure equity holdings in strong bull markets, which can be surprising for those expecting both income and growth.

Another underappreciated risk is limited downside protection. While option premiums provide a shock absorber against small declines, they do little to offset large drops in the value of the underlying stocks. Covered call ETFs are not a substitute for true hedging strategies.

Perhaps one of the most important risks — but one that may not be fully appreciated — is in assessing the skill of the fund’s portfolio manager in selecting both the underlying stocks and implementing the options overlay. Given the importance of the options overlay to generate the level of distribution investors are looking for, the depth and experience of the derivatives team is essential to success and paramount for investors to be aware of when making decisions.

Covered call ETFs do not eliminate equity risk, and their performance may lag in rapidly rising or falling markets. Proper education and realistic expectations are essential to avoid surprises.

Implementing a covered call strategy across a diversified portfolio of 20 to 100 stocks presents several key challenges compared to managing the strategy on a single stock. First, ETF portfolio managers must continuously monitor the price movements, volatility, and option markets for each stock in the portfolio, which requires significant expertise and robust systems. Selecting appropriate strike prices and expiration dates for each holding is complex, as individual stocks may react differently to market events, earnings or sector trends.

Managing the overall portfolio risk and ensuring consistent income generation is more difficult at scale, as the optimal covered call approach may vary for each security. The ETF portfolio manager must also balance the trade-off between income and potential capital appreciation, so that the strategy does not excessively cap upside or expose the fund to unintended risks.

Liquidity is another challenge: some stocks may have less liquid options markets, making it harder to efficiently execute trades or achieve desired premiums. Additionally, synchronizing option expiries and managing assignments across multiple positions can be operationally intensive.

Investors may prefer a covered call strategy when their primary objective is to generate enhanced, regular income from their equity holdings, especially in flat or range-bound markets where capital appreciation is limited. Covered call ETFs can provide higher monthly cash flow by combining dividends with option premiums, making them particularly attractive for retirees, income-focused investors, or those seeking to supplement fixed income allocations in a tax-advantaged way. These strategies also offer moderate volatility reduction, but with the trade-off of capped upside in strong bull markets.

On the other hand, ETFs that employ dividend growth strategies are often favored by investors seeking long-term capital appreciation and rising income over time. These strategies focus on companies with a history of consistently increasing dividends, which can signal financial strength and resilience. Dividend growth portfolios tend to perform well in steadily rising markets and offer some protection during downturns due to their quality bias.

Low-volatility strategy ETFs are often preferred by investors who prioritize capital preservation and reduced risk, especially in uncertain or declining markets. These portfolios target stocks with historically lower price fluctuations, aiming to deliver smoother returns and limit drawdowns.

Ultimately, the choice depends on the investor’s goals: covered call ETFs for income and moderate risk reduction, dividend growth ETFs for rising income and growth, and low-volatility ETFs for maximum downside protection.