Advisors weigh use of covered-call ETFs as S&P 500 keeps rising

The S&P 500 keeps climbing, but that hasn't stopped advisors from running for cover – covered calls, that is.

At least not yet.

The S&P 500 soared more than 24% in 2023 as investors piled into stocks, especially the so-called Magnificent Seven big-cap tech names that have been fueled by the promise of AI. In the end, it was a pretty remarkable result considering the repeated recession calls by Wall Street economists throughout the year.

Nevertheless, despite that impressive return, investors did not fully forget the pain of the almost 20% S&P 500 sell-off in 2022. That's partially evident from the increase in inflows into covered-call ETFs in 2023. Advisors and investors stepped up their use of these hedged products to the tune of more than $20 billion in inflows last year, bringing the product total past $60 billion, according to Morningstar.

A solid portion of those flows went into the category leaders JPMorgan Equity Premium Income ETF (JEPI) and JPMorgan Nasdaq Equity Premium Income (JEPQ) which at last check boasted assets of $31.6 billion and $9.5 billion, respectively.

Covered-call ETFs use options strategies to generate high yields, reduce portfolio volatility and offer some safeguard when stocks fall. To guarantee that downside protection, however, they simultaneously sacrifice upside.

And capturing that upside has remained all the rage so far in 2024. The appetite for stocks remains undiminished with the S&P 500 jumping over 5% year-to-date. The bellwether index is now flirting with the record 5000 level.

The big question now facing covered-call ETF holders is whether they should banish those bear market memories and let their index holdings ride uncovered.

Stephen Kolano, chief investment officer at Integrated Partners, says he uses covered-call ETFs in client portfolios because they provide a source of income that is less correlated with overall capital markets and more tied to volatility.

“One of the inputs into pricing options is volatility and so by including these types of strategies allows us to add an additional layer of diversification to client portfolios by mitigating that volatility tax that many asset classes incur with market volatility,” Kolano said. “It instead allows us to add a component of the portfolio that benefits from an increase in volatility which usually coincides with unexpected or exogenous market events.”

Kieran Kirwan, senior investment strategist at ProShares, believes the strategy will stay popular in coming years, no matter the market direction, because of its simplicity.

“You have a long portfolio of stocks and then you have an option strategy where the portfolio may write or sell calls on that to generate levels of income, and they've been popular because those levels of income have been very attractive double-digit yields,” Kirwan said. “You can't really get that in other areas of the market these days, or in fixed income, for example.” 

Last December, ProShares launched a new entry into the covered-call ETF canon called the ProShares S&P 500 High Income ETF (ISPY) which employs a strategy based on daily call options, as opposed to a monthly one. The expense ratio for the ISPY is 0.55% while its latest monthly distribution, which is being paid Thursday, is generating an annualized yield of 11.3%. 

Kirwan says the fact that it captures the premium from daily call options, instead of monthly ones, enables it to capture more of the index returns that traditional covered-call strategies often sacrifice.

He says the ISPY fits well into a diversified portfolio because it behaves a lot like a normal, unhedged S&P 500 ETF, and unlike traditional covered-call strategies that use monthly options rather than daily ones.

“Traditional covered-call strategies are neither fish nor fowl,” Kirwan said. “They have lower sensitivity to the overall market. Some elements of an alternative strategy, some elements of a fixed-income strategy, so it becomes more difficult to utilize in a diversified portfolio.”