Covered Call ETFs: A High-Yield Income Strategy for Investors

闲云野鹤

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A covered call is an investment strategy used to generate income and potentially hedge against downside risk. It involves buying a stock or a basket of stocks and then selling or writing call options on those same assets. These options give the buyer the right, but not the obligation, to purchase the stocks at a predetermined price before a specified date.

If the stocks rise above a specified “strike” price, the fund pays the buyer of the option the difference between the stock price and the strike price. However, if the stock declines or simply stays below the exercise price, the fund keeps the income paid by the option buyer. That premium is passed on to fund holders, which is a big attraction for many investors. Most ETFs write monthly call options and pay out the premium they earn at the end of each month (read: S&P 500 Logs Worst Month of 2023: 5 Stocks Still Up in ETF).

With this process, the ETF portfolio aims to generate additional monthly income from the call option (premiums collected). The income from option premiums can help to offset losses from the underlying stocks, which can potentially result in lower portfolio volatility. This means that covered call strategies might experience smaller price swings compared to a pure equity investment.

The main drawback is that the written call options cap the gains of the ETF. During bullish markets, the ETFs might underperform as the profits from rising stock prices are partially offset by the losses on the call options. As such, the strategy outperforms in neutral to bear markets but underperforms in bull markets in the short term.

Additionally, the fees associated with the management of the covered call strategy, along with the ETF’s expense ratio, could erode the fund's returns, especially if the strategy fails to generate the expected income. Further, the tax treatment of the payouts is another concern. The cash flow sometimes isn’t tax-efficient because part of the income can be taxed at the short-term capital gains rate.

Investors seeking to make a play on the stock market using this strategy have many options available in the space. We have highlighted some of the popular ETFs with rock-solid yields below:

JPMorgan Equity Premium Income ETF (JEPI)

JPMorgan Equity Premium Income ETF is an actively managed fund that seeks to provide current income while maintaining prospects for capital appreciation. It generates income through a combination of selling options and investing in U.S. large-cap stocks, seeking to deliver a monthly income stream from associated option premiums and stock dividends. JPMorgan Equity Premium Income ETF has AUM of $29 billion and charges 35 bps in annual fees. The product trades in an average daily volume of 4 million shares and sports an excellent yield of 9.98% (read: 5 ETFs That Pulled in Maximum Assets in the First Nine Months).

Global X Nasdaq 100 Covered Call ETF (QYLD)

Global X Nasdaq 100 Covered Call ETF follows a “covered call” or “buy-write” strategy, in which the fund buys the stocks in the Nasdaq 100 Index and “writes” or “sells” corresponding call options on the same index. It seeks to track the Cboe Nasdaq-100 BuyWrite V2 Index. Global X Nasdaq 100 Covered Call ETF has $7.7 billion in AUM and trades in a solid volume of 4.7 million shares a day on average. It charges 60 bps in annual fees from investors and has higher yields of 12.25%.

JPMorgan Nasdaq Equity Premium Income ETF (JEPQ)

JPMorgan Nasdaq Equity Premium Income ETF generates income through a combination of selling options and investing in U.S. large-cap growth stocks. It seeks to deliver a significant portion of the returns associated with the Nasdaq 100 Index with less volatility. JPMorgan Nasdaq Equity Premium Income ETF has AUM of $5.6 billion and charges 35 bps in fees per year. It trades in an average daily volume of 2 million shares and has a massive dividend yield of 12.09%.

Global X S&P 500 Covered Call ETF XYLD

Global X S&P 500 Covered Call ETF buys stocks in the S&P 500 Index and “writes” or “sells” corresponding call options on the same index. It tracks the Cboe S&P 500 BuyWrite Index, charging 60 bps in fees per year. Global X S&P 500 Covered Call ETF has amassed $2.8 billion in its asset base and trades in a good volume of 466,000 shares. It has a solid yield of 11.45% (read: Time to Bet on Buy-Write ETFs).

Global X Russell 2000 Covered Call ETF (RYLD)

Global X Russell 2000 Covered Call ETF buys stocks in the Russell 2000 Index (at times by exposure to the Vanguard Russell 2000 ETF) and “writes” or “sells” corresponding call options on the Russell 2000 Index. It follows the Cboe Russell 2000 BuyWrite Index and charges 60 bps in fees per year. Global X Russell 2000 Covered Call ETF has AUM of $1.5 billion and trades in an average daily volume of 793,000 shares. It has a solid yield of 13.27%.

Amplify CWP Enhanced Dividend Income ETF (DIVO)

Amplify CWP Enhanced Dividend Income ETF is an actively managed ETF of high-quality large-cap companies with a history of dividend growth, along with a tactical covered call strategy on individual stocks. It has accumulated $2.9 billion in its asset base and charges 55 bps in fees per year. Amplify CWP Enhanced Dividend Income ETF trades in a good volume of 342,000 shares and has an annual yield of 4.99%.

iShares 20+ Year Treasury Bond BuyWrite Strategy ETF (TLTW)

iShares 20+ Year Treasury Bond BuyWrite Strategy ETF seeks to provide enhanced income compared to traditional U.S. Treasury bonds by selling monthly covered call options. It may outperform in periods of rising rates. With AUM of $651.7 million, iShares 20+ Year Treasury Bond BuyWrite Strategy ETF charges 35 bps in annual fees and trades in average daily volume of 516,000 shares. It has a solid yield of 21.56% (read: Inverse Treasury ETFs Surge as Yields Rise).

WisdomTree PutWrite Strategy Fund (PUTW)

WisdomTree PutWrite Strategy Fund tracks the Volos US Large Cap Target 2.5% PutWrite Index. On a monthly basis, it sells short two put options on the SPDR S&P 500 ETF Trust SPY with different expiration dates. The proceeds of these option sales and other collateral are invested in U.S. 3-Month Treasury Bills. WisdomTree PutWrite Strategy Fund has amassed $86.1 million in its asset base while charging 44 bps in annual fees. The product trades in an average daily volume of 25,000 shares and has a solid yield of 10.27%.

https://www.tradingview.com/news/benzinga:41c0a3196094b:0-qqqi-the-undiscovered-nasdaq-100-covered-call-etf-you-ve-been-looking-for-14-4-distribution-yield/

Nasdaq-100 Covered Call ETF You've Been Looking For (14.4% Distribution Yield)Mar 15, 202415:32 EDT

JEPI−0.61%XYLD+0.27%SPYI−0.46%QQQI−0.83%

A few months ago, I analyzed the total performance of the three most popular S&P 500 covered call ETFs in 2023: the JPMorgan Equity Premium Income ETF JEPI, the GlobalX S&P500 Covered Call ETF XYLD, and the NEOS S&P 500 High Income ETF SPYI.

The covered call ETF that came out on top was the NEOS S&P 500 High Income ETF for three reasons: they had full exposure to the holdings inside of the S&P 500, wrote out-of-the-money covered calls, and used Section 1256 contracts for enhanced tax-efficiency.

The total performance of SPYI in 2023 was 18.1%, capturing nearly 69% of the S&P 500 Index's total return last year. Compared to the JPMorgan Equity Premium Income ETF's total return of 9.8%, and the GlobalX S&P 500 Covered Call ETF's total return of 11.0%.

I share these figures because the team that built SPYI — and all of the category leading performance that came with it — has used the same techniques and strategy to build the NEOS Nasdaq-100 High Income ETF QQQI.

What Is QQQI?

The NEOS Nasdaq-100 High Income ETF is an ETF that aims to offer high monthly income in a tax-efficient manner and upside potential when the Nasdaq-100 Index (QQQ) rises.

Let’s break that down simply — as we all know, an ETF is a basket of stocks.

In this case, the basket is constructed to replicate the holdings of the Nasdaq-100 Index. Remember, the Nasdaq-100 Index sits right next to the S&P 500 Index in popularity and portfolio construction. This index tracks the total performance of the 100 largest, most-actively traded stocks listed on the Nasdaq. Think Apple AAPL, Microsoft MSFT, Nvidia NVDA, Broadcom AVGO, Meta Platforms META, Tesla TSLA... you get the picture.

The Nasdaq-100 Index delivered +54.9% returns for its investors in 2023, the best year since 1999. Again, this was largely due to the AI craze we saw by companies like Microsoft, Nvidia, and others — but incredibly impressive nonetheless.

So, what's the difference between QQQ and QQQI?

A single letter, I.

And that letter stands for income.

Think about it like this — a 55% return in an investment is awesome. However, to realize that return in your bank account, you’ll need to sell shares of stock. Considering the trailing twelve month dividend yield of the Nasdaq-100 Index is 0.52%, 99.48% of that return was in the form of share price appreciation — not cash dividends paid to you.

But what if there was an ETF that aimed to offer exposure to the Nasdaq-100 Index while also optimizing for tax-efficient income for their shareholders?

Enter QQQI.

The NEOS team has successfully done this with their S&P 500 Index equivalent ETF, SPYI — paying a 12.14% annual distribution yield (as of 3/15/24) to investors while also allowing their share price to trend higher over time. Again, SPYI delivered a total return of 18.1% in 2023 — with 12% of that being paid out as monthly income to their shareholders.

I’m a shareholder in and receive monthly income from SPYI.

Now the team is introducing QQQI — a way for income-focused investors to have exposure to the Nasdaq-100, in a tax-efficient manner.

How Does QQQI Work?

Let’s start by understanding how the normal QQQ ETF works — by investing into the same stocks that represent the Nasdaq-100 Index, the QQQ ETF experiences the same return as the Nasdaq-100 Index.

Simple enough, right? Have the same stuff, experience the same returns. I mean, this is precisely how every index-focused ETF works.

So, what does QQQI do?

They hold the exact same stocks in the exact same weightings as the Nasdaq-100 Index, as shown below. Therefore it should perform similarly to the Nasdaq-100 Index, but why not exactly the same...?

Covered call option contracts.

Let’s break what that means — NEOS says “We’re going to sell Nasdaq-100 covered calls against our holdings. We’re going to choose a date that’s about 1-month into the future, and a strike price up to 5% out-of-the-money.”

In return, they receive premium income from the buyer of those option contracts. They take that premium income and pay it out in the form of a monthly distribution to their shareholders.

Now that you understand the high-level strategy — let’s walk through the specific intricacies that set them apart from other Nasdaq-100 income-focused ETFs on the market today.

Section 1256 Contracts:

These are the type of “option contracts” they chose to use when selling their covered calls. Long-story short, the income produced when using these contracts is taxed at 60% long-term capital gains, and 40% short-term capital gains.

Compare this to the 100% short-term capital gains investors have to pay on their income when selling “normal” covered calls. Over the long-haul, we’re talking about a material savings on taxes when Uncle Sam comes knocking.

Out-of-the-Money:

By selling their option contracts “OTM,” they’re ensuring their investors can participate in upside share price appreciation.

Here’s what I mean — when you sell an at-the-money covered call, you’re guaranteeing your return upfront. If the price of the underlying equity trades higher than the total amount of premium you’ve received, too bad.

Because the NEOS team is selling covered call option contracts up to 5% OTM, investors are able to participate in some upside share price appreciation.

Sure, if the Nasdaq-100 increases by +10% in a single month — QQQI investors won’t realize that entire 10% return because they’re only writing contracts to include up to +5% in share price appreciation. But that’s the “trade-off” you make when you’re trying to optimize for tax-efficient income vs. share price appreciation.

This is very different from the GlobalX Nasdaq 100 Covered Call ETF, QYLD. Their option contract strategy sells "at-the-money" covered calls, capping the upside to the total premium generated by selling the contract. There is not upside share price appreciation participation with "ATM" covered calls.

Early Innings

Considering this ETF just launched late-January, we're still in the early innings of tracking its performance relative to the GlobalX Nasdaq 100 Covered Call ETF. With that being said, QQQI announced their first monthly distribution a few weeks ago at $0.5939 per share.

At time of writing (3/15/24), this comes out to be a 14.42% annual distribution yield, a whopping +2.8% higher than QYLD's 11.62% distribution yield.

Will this higher distribution yield sustain? It's anyone's guess.

However, SPYI paid investors $5.80 per share in 2023, a 12.0% yield against their $48.20 closing price on December 29, 2023 - coming in at +1.5% higher than XYLD's 12-month yield using the same time frames. And because they wrote "out-of-the-money" covered calls, the price of SPYI appreciated by +2.1% (from $46.26 to $47.24) during 2023 compared to XYLD's -1.7% (from $39.56 to $38.84).

If history repeats itself, QQQI's out-of-the-money covered call option contract strategy might outperform QYLD's at-the-money covered call option strategy from a total return perspective in 2024. However, we'll have to wait and see.

Downside Risks

As with any covered call ETF, the downside risk is obvious - underperformance in relation to the index the ETF is tracking. However, we haven’t yet seen this take place with QQQI in 2024.

Since inception on January 30th, QQQI's total return has been 1.9% (as of 3/15/24). During the same period of time, QQQ's total return has been 1.6% (as of 3/15/24). The reason for the slight outperformance has to do with the premium collected when selling their out-of-the-money covered calls.

Simply put, QQQ has been trading sideways since mid-February — resulting in a zero total return to investors over the last month or so. Considering QQQI aims to offer exposure to the same index, it makes sense that QQQI’s stock price has also traded sideways during the same period of time. However, because QQQI seeks to distribute high monthly income for their investors and subsequently paid a $0.5939 per share distribution on February 23rd — in stagnant markets QQQI comes out on top.

QYLD's total return during the same time period has only been 1.4% (as of 3/15/24) — 50 bps lower than QQQI's — given their at-the-money covered call option contract strategy.

Time will tell just how much QQQI might underperform or outperform QQQ in 2024. Again, in 2023 SPYI only captured ~69% of the S&P 500 Index's total return. With that being said, I'm not going to begin to speculate where QQQI might land in relation to QQQ's total performance for 2024.

Conclusion

The same team that built the category leading S&P 500 covered call ETF, SPYI, has introduced a new covered call ETF, QQQI. This covered call ETF uses Section 1256 contracts to ensure tax-efficiency, writes out-of-the-money covered call option contracts, and is already beginning to show strong results early on.

As with all investments, it's important to spend time observing performance in relation to their fund's investment objective as outlined in their prospectus. When comparing very early results to "the next best thing," performance looks promising. With that being said, I look forward to revisiting QQQI's performance in 6-9 months once we've seen more distributions paid to investors.

As a fellow income-focused investor, I'm always weighing my options in efforts to determine the best possible way to invest my money. At time of writing, I'm eager to expand my small-but-growing position in QQQI. If you're interested in doing your own research on QQQI, I found this interview on YouTube to be helpful.

This article is from an unpaid external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.

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