Stocks are high, volatility is low. Time to sell or buy covered-call ETFs?

Rick Wedell of RFG Advisory and Steve Kolano of Integrated Partners

While yields have dipped for many covered-call ETFs, they’re still above yields on many bond funds and most dividend funds.

Volatility is at historic lows, reducing the premiums on covered-call strategies. Meanwhile, equity indexes are at record highs, limiting the risk that the underlying stocks get called away. So is this the best or worst of times to allocate assets to covered-call ETFs?

There was increased interest in covered-call ETFs among both advisors and investors last year, according to Morningstar, with billions pouring into the option overlay strategies. In February, the covered-call ETF category totaled more than $67.6 billion in assets, up from $309 million only a decade ago.

And why not? The ETFs generally pay high dividends and reduce the volatility in a portfolio, while still offering the hope of some capital appreciation, even if it is capped at some point.

For example, the JPMorgan Equity Premium Income ETF (JEPI), which launched in May 2020, grew to more than $32.8 billion in assets after taking in over $12.7 billion in new money from investors last year. JEPI was yielding 7.9 percent at last check and returned 9.8 percent in 2023. Part of the fund’s strategy is to sell call options with exposure to the S&P 500 Index, which returned more than 24 percent last year.

Elsewhere, the Global X Nasdaq 100 Covered Call ETF (QYLD) collected more than $870 million in new money in 2023, according to Morningstar. At last check, QYLD held over $8 billion in assets and posted a yield of 11.5 percent. The QYLD performed well last year, but also failed to beat the unconstrained index, rising 22.9 percent.

Last December, Gateway joined the party with the launch of the Natixis Gateway Quality Income ETF (GQI), a $75 million income-oriented equity strategy using an options overlay. GQI currently sports a 30-day yield of 7.5% percent with a targeted yield of between 8 percent and 12 percent annually, according to Joe Ferrara, investment strategist at Gateway Investment Advisers.

Zachary Evens, manager research analyst at Morningstar, says fund flows tapered off a little toward the end of 2023 as equity markets rebounded. But they picked back up during the first couple of months of 2024, likely because investors thought the market was overvalued and saw these funds as a way to stay invested and earn income, while hedging their stock market risk.

“While yields have dipped a little, for many covered-call ETFs, they’re still above many bond funds and most dividend funds,” Evens said. “However, with lower yields on these products, investors may look to bond funds instead to satisfy their income requirement – many bond funds offer competitive yields with less expected risk than covered-call funds.”

HIGHER (RATES)/LOWER (VIX) FOR LONGER

Sticky monthly inflation numbers thus far this year have most strategists cutting back on their rate cut predictions for 2024. If rates do stay higher for longer, Ferrara says it’s actually a positive aspect for his strategy, despite the thought that investors might jump to bond funds instead.

“If you think about option pricing or option math and some of those models, the absolute level of the market, its interest rates and its volatility, so really anything away from zero is very positive for a strategy like ours that seeks to generate cash flow,” he said.

Meanwhile, the VIX, which tracks volatility and was in the 30s for much of 2022, has fairly steadily dropped throughout 2023 and into early 2024. It now sits around 13, which is pretty much its low point for the past five years.

As a result, Rick Wedell, chief investment officer at RFG Advisory, said he would caution investors about adding to these types of strategies today, given that the premium that being paid to write insurance on the market is at a historically low level versus recent history.

“In other words, you aren’t getting paid that much for the strategy today versus really any time in the prior five years,” Wedell said.

On the flip side, Christopher P. Davis, partner at Hudson Value Partners, says volatility has nowhere to go but up, and any time volatility is picking up or prices seem to be extended is a good time to think about covered-call selling.

“When used in conjunction with your price target or to trim a position, covered calls are a way to generate income and stay disciplined. Just be sure you are actually willing to sell the shares at the strike price plus the premium collected, otherwise you will be chasing your tail,” said Davis.

Luke Keene, chief investment officer at Leverty Financial Group, is leaning into the covered-call strategy despite the increasing probability of an economic soft landing, primarily because the current geopolitical, situation and economic risks still necessitate careful risk management.

“As market volatility increases, so does the potential for incremental income within the strategy,” Keene said. “While it may underperform when broad markets rally, like in the fourth quarter of last year, we believe the income it provides and the risk offset against the potential 2024 headwinds, like the election and the return of inflation, are a favorable trade-off. In essence, we are providing our clients an equity exit hatch should the need arise.”

Stephen Kolano, chief investment officer at Integrated Partners, also uses strategies that have an options-based component in them. Right now, with the VIX scraping along the bottom of its historical range, he’s buying cheap protection rather than selling options to scoop up premium.

“Volatility has been below longer-term averages recently and as such it is potentially an attractive time to be buying volatility-based strategies given the potential for volatility to increase in the coming quarters,” he said.