Like many financial advisors in areas with lots of retirees, H. Parker Evans is constantly searching for ways to boost portfolio income, especially in a low interest rate environment. But unlike most of his peers, the president and chief investment strategist of the Clearwater, Fla.-based firm Successful Portfolios uses covered call writing on exchange-traded funds to accomplish that goal.
“Some client portfolios must generate a certain level of income, and in those situations, covered call writing can be an attractive asset,” he says. “I’d rather be using covered calls than junk bonds to meet income needs.”
Certainly, the appeal of bonds as income generators has waned because of stubbornly low interest rates, and also because of concerns about how rising interest rates and political stalemates may impact those bonds. If the market settles into a holding pattern after a long bull run—an environment in which covered call writing tends to shine—more advisors might gravitate to Evans’ way of thinking.
So far, however, that hasn’t happened. An e-mail from a spokesperson at a major broker-dealer in response to a request for viewpoints on ETF covered calls drives home the point: “We canvassed some advisory firm clients and have not been able to find anyone who either uses such strategies or has a strong/clear opinion either way.”
A number of reasons might explain why scrounging up investment professionals who use the strategy, or even have an opinion about it, is so difficult. Those who use ETFs are often indexing enthusiasts who value simplicity over mastering a niche practice that takes a long time to understand and limits upside potential during bull markets. Diversified ETFs are generally less volatile than individual securities, so their premiums aren’t as rich. (For an explanation of how covered calls work and how volatility affects premiums, see the sidebar).
According to some studies, covered call writing may not do better than simple buy-and-hold in the long run. In an article on Seekingalpha.com titled “Selling Covered Calls On Most ETFs Guaranteed To Lose You Money In The Long Run,” Optionize.net founder Derek Tomczyk concluded that, based on historical price patterns, a covered call writing strategy using the Standard & Poor’s 500 ETF (SPY) would be expected to outperform a simple buy-and-hold strategy between 75% and 90% of the time, depending on the particular option. However, the magnitude of the upturns during the 10% to 25% of the time that buy-and-hold works better—when the options would be surrendered at relatively low prices—translates into higher long-term returns for investors who don’t use covered calls.
“It’s not impossible to make money writing covered calls,” he writes. “In fact, you will make money the majority of the time. However, unless you have tested rules to determine when to write calls and when not to, you are going to lose money [in comparison to buy-and-hold] mechanically writing calls over the long run.”
The dismal performance of PowerShares S&P 500 BuyWrite (PBP) against the index supports that conclusion. Over the mostly bullish five-year period ending September 30, the ETF had a 3.19% annualized return, versus 10.02% for the index.
Nonetheless, Evans says the strategy appeals to conservative clients who prefer small but consistent profits over outsize gains during market run-ups. “The ideal client for covered call writing is someone who is risk averse, needs a certain amount of income from his investments each month, and isn’t too concerned about keeping pace with the S&P 500 index,” he says. He estimates that the value of the ETFs he uses for covered calls is usually no more than 5% of someone’s total portfolio assets, and in the vast majority of cases he uses covered calls “tactically and selectively.” This year, for example, writing call options on struggling emerging market ETFs has cushioned losses and generated income.
Paul Kadavy, author of the book Covered Call Writing With Exchange Traded Funds (Arrow Publications), uses covered calls on almost all his ETF and individual stock positions to generate income in his personal portfolio. His objective is to achieve a 12% annualized return through a combination of appreciation on the underlying securities and the option-writing income. Predictably, his portfolio stacks up best against a simple buy-and-hold strategy in down or meandering markets, but often lags during more bullish times.
Kadavy, who is retired, says that for him the ability to generate regular income and provide some downside protection for his portfolio is worth giving up some upside in bull markets.
“I think there is a great deal of misunderstanding about the risks associated with options,” he says. “The use of covered calls is actually more conservative than simple ownership of individual stocks and ETFs because the options provide some downside protection.”
Kadavy and other experts offer some advice for those interested in testing the waters:
Start slowly. Brush up on options strategies through seminars, books and discussions with investment professionals who use them regularly. If this is new territory, test-drive the strategy in a personal account first to get a feel for how it works.
Trade in bulk. Discount brokers usually charge a flat fee per transaction, plus a small amount for every 100-share options contract. Because even a low $10 commission could eat away at returns for smaller trades done repeatedly, you can save money and keep more profits by trading multiple contracts at once.
Keep taxes in mind. The premiums generated by writing covered call options are generally taxed at ordinary income rates, so it’s preferable to have short- or long-term capital losses to offset option-writing income in taxable accounts or to use the strategy in tax-deferred accounts. The tax is triggered when the options expire, not when the investor writes the option and receives the premium. That means an options writer can earn a significant premium at the end of the year and postpone paying taxes on the income until the year the options expire.
Set limit orders. While options on larger ETFs have an active market and are fairly liquid, daily trading volume for smaller ones may be limited. To avoid having the order filled at a low price on thinly traded ETF options, set a limit order at an acceptable price.
Diversify positions. Using a variety of expiration dates can serve as a safeguard against having ETFs called all at once if there’s a broad market rally. Using different strike prices would also provide a similar diversification benefit.
The Funds Route
Advisors who want to introduce a covered call strategy through diversified funds that use them have three options.
ETFs. Covered call ETFs are relatively new and have yet to draw much money. At $177 million in assets, PowerShares S&P 500 BuyWrite, launched in 2007, is the oldest and largest of this four-member club. Others include AdvisorShares STAR Global Buy-Write ETF (VEGA), iPath CBOE S&P 500 BuyWrite ETN (BWV) and Horizons S&P 500 Covered Call ETF (HSPX).
Closed-end funds. Morningstar lists 31 covered call closed-end funds from companies such as BlackRock, Cohen & Steers, Eaton Vance, Nuveen and ING. Analyst Cara Esser cites BlackRock Enhanced Capital & Income (CII), BlackRock Global Opportunities (BOE) and Nuveen’s suite of closed-end covered call funds as standouts in the group.
Mutual funds. Only a handful count them as a major part of their strategy on a consistent basis. The best-known of these, the Gateway Fund (GATEX), has delivered slow but steady gains to investors since its inception back in 1977. While the $7.7 billion fund underperforms the S&P 500 during bull markets, this low volatility turtle lumbers past the index on a risk-adjusted basis over the long term.