Covered call ETF demand still surging despite bull market, rising bond yields

Equities have been streaking in the past year with indexes repeatedly marking record highs. Nevertheless, the bull run in stocks has not stopped advisors from running for cover.

Covered call ETFs that is.

The number of covered call ETFs, or as Morningstar calls them “derivative income” ETFs, in the market has nearly doubled to 75 from 39 in the past year, according to Morningstar. In terms of net assets, the category has jumped to more than $74.8 billion at the end of May, up from $46.5 billion the prior year.

Morningstar defines derivative income strategies as those using options overlays, like covered calls, to generate income while maintaining exposure to equity market risk.

Simeon Hyman, strategist at ProShares, says the soaring demand for covered call ETFs is due to their ability to generate income, which investors are still seeking despite the rise in bond yields over the past few years. 

“They have become popular because, up until recently, bonds were broken,” said Hyman. “Quantitative easing had artificially suppressed yields, and therefore bonds couldn’t do you any good from a diversification standpoint.”

Josh Hawkins, vice president of financial planning at Leverty Financial Group, uses the JPMorgan Equity Premium Income ETF (Ticker: JEPI) to manage risk for his clients. The JEPI, which yields 7.34 percent at last check, incorporates equity-linked notes and an options overlay strategy to reduce volatility and provide downside protection.

“We believe that JEPI’s options overlay strategy is ideal for retirees and clients nearing retirement based on current market valuations,” said Hawkins. “JEPI gives them exposure to the S&P 500, while enhancing yield through options premiums, balancing growth and income.”

Seth Hickle, managing partner at Mindset Wealth Management, does not use covered call ETFs in client portfolios on a widespread basis. That’s because he offers covered call strategies executed directly in client accounts.

“We as a firm have the option expertise, time, and capacity to take an individualized approach for each client’s portfolio. This allows clients to benefit from a strategy customized to their individual needs and goals,” said Hickle.

He says he often executes covered calls on positions already held in a client account or on individual securities as opposed to an index. This approach allows him to maximize the amount of premium received while also offering opportunities to “roll the calls out and up” if the opportunity arises, giving him a chance for capital appreciation.

“Many covered call ETFs are capped on the upside and do not roll options positions to maximize premium or market appreciation,” said Hickle, adding that expense ratios can also be on the higher side as there are more “moving parts” to the management of the strategy. The JEPI, for example, has an expense ratio of .35 percent, which is almost four times the cost of the average index ETF.

On the flip side, Pat Nerney, senior vice president of Investments at Dynasty Financial Partners, says using a covered call strategy on a broader index should only be used if you think the index will be in a sideways market. The S&P 500 has been anything but treading water in the past year, rising 24 percent.

As a result, he believes this strategy should be used tactically as a complement to a direct long holding of the underlying index.

“Over the last 1 and 3 years from an opportunity cost perspective you’ve been killed relative to just holding the index outright,” said Nerney.

Similarly, Sean Beznicki, director of investments at VLP Financial advisors, would rather not cap his upside, especially when Wall Street’s bulls are stampeding.

“We refrain from using covered call ETFs due to their complexity and limited upside potential. However, we acknowledge the strategy’s appeal, especially for the income generated through option premiums,” said Beznicki.

Related Topics: ETFs, Exchange-traded funds, Morningstar, Stock Options