Today, with the market bouncing up and down (but never too far either way), investors are flocking to covered-call funds—also known as option-income funds. And why not? With some yielding more than 11%, these funds have an undeniable appeal. But are they overhyped? And for whom and when do they make the most sense?

Here are a few expert perspectives on this strategy.

The Mechanics
Covered-call funds are a class of derivative-income investing. They can earn yields that are even larger than those currently available from Treasury notes by selling (sometimes called “writing”) call options on assets within the fund.

Many popular covered-call funds are exchange-traded funds, but others are not. Either way, the fund manager can sell an option on any of the underlying assets to a third party at a predetermined “strike price” that’s above the current price. The option has an expiration date. If the asset appreciates before that date, the buyer gets a bargain, and you have to give up the asset at a discount. If it loses value before the expiration date, the option can simply expire.

But whether or not the option is exercised, the option buyer must pay an up-front premium for it—a premium that goes in your pocket no matter what happens to the asset.

A Strategy For The ‘Sideways’ Market
“These funds are not designed to keep up in a bull market,” says Austin Graff, founder and chief investment officer of Opal Capital in Boca Raton, Fla. “They tend to work best for retirees, and those nearing retirement, who are looking for current income or reduced volatility.”

To Graff, covered-call funds are “better than fixed income,” he says, because “the strategy preserves more equity upside relative to bonds or bond laddering.”

Michelle Connell, owner and chief investment officer at Portia Capital Management in Dallas, goes further: “This strategy saved my performance last year,” she says. “I use it as a building block of my portfolios.”

In early 2022, when she felt the market was already fully valued, Connell increased her position in the JPMorgan Equity Premium Income fund, which is a mixed bucket of blue-chip stocks and covered-call options. Last year, while the S&P 500 plunged more than 18%, the fund was down less than 4% (including dividends and covered calls). “The strategy did what it was supposed to do,” says Connell.

Moreover, between regular dividends on the shares and the option premiums, the fund’s average monthly yield was more than 11%. “If you want bonds to earn the same kind of yield, you’re going to have to take on a fair amount of interest rate risk and/or credit risk,” she says.

No wonder the fund took in nearly $13 billion of new money last year.

A Multipronged Approach
Hamilton Reiner, lead manager of the fund at J.P. Morgan Asset Management in New York City, says his objective is “to balance income and total returns over the long term.”

The fund, he explains, may be a good fit for clients who want to balance their portfolio with “a conservative equity solution and diversified source of total returns,” he says. “We think about the strategy as a three-pronged approach: total returns through dividends, options premiums, and potential capital appreciation.”

Yet other covered-call funds have a different orientation. “There is a wide range of derivative income funds,” says Christian Magoon, CEO of Amplify ETFs, a Lisle, Ill.-based ETF specialist firm. “Some automatically write covered calls each month … while others are actively managed and only write calls tactically. There are many nuances.”

For instance, the New York-based ETF investment firm Global X ETFs has a covered-call ETF linked to the Nasdaq-100 index, and its performance benefits from dividends and covered calls. So even though the Nasdaq-100 lost 33% last year, the Global X fund that’s tied to it lost only 19%, giving investors a 14 percentage point advantage.

According to Rohan Reddy, Global X ETFs’ research director, the yield from covered calls on the ETF totaled more than 39% in 2022, or 3.3% per month on average. Nearly $3 billion of new money flowed into it, in part because of the popularity of tech stocks, says Reddy.

“We’ve seen investors with cash flow needs across all demographics utilize covered call strategies,” he says. Besides collecting premiums on the options, investors like that they “aren’t forgoing significant equity upside in a bull market, and they’re not taking on the majority of downside during bear markets,” says Reddy. “This is part of the reason why investors have been moving more into these strategies.”

A Few Caveats
Still, not everyone is convinced about the merits of the covered-call strategy. Charles Lewis Sizemore of Sizemore Capital Management in Dallas says it’s important to remember that there’s a stock portfolio beneath these covered calls, and that portfolio can still endure wild swings in value.

The strategy can be “a nice, supplemental income source,” he concedes, “a way to generate a little extra income off of your stock portfolio.” But it should not be used as “an income strategy to pay your bills in retirement,” he says. “Varying payouts are a real risk, as are market losses.”

The way the funds are marketed can be misleading, too, critics contend. “This strategy should not be pitched as a hedge,” says Patrick Nerney, vice president of investments at Dynasty Financial Partners in St. Petersburg, Fla. “It drives me nuts when people say these funds give ‘partial downside protection.’” The premiums aren’t going to be enough to offset steep market declines, he explains, nor enough to compensate for being forced to sell some assets at a bargain price.

Stacking Up Against Annuities
Some market observers say that if investors are looking for income, annuities are the better way to go. “A covered-call fund has a lot of emotional appeal, but I wouldn’t consider it to be a substitute for an annuity,” says Michael Finke, professor of wealth management at the American College of Financial Services in King of Prussia, Pa.

Annuities offer the advantage of tax deferral, he says, and their payout rates can be guaranteed, unlike covered-call funds, providing “a reliable source of funding for inflexible retirement expenses.”

But others see the comparison differently. “The traditional covered call does not have the high fees and [cash] lockup issues that most annuities have,” says Joseph Cusick, a senior vice president and portfolio specialist focusing on hedged equity strategies at Calamos Investments in Chicago.

Furthermore, Cusick says that while covered-call funds won’t beat a bull market, bull markets only last so long.

Indeed, with its current sideways price movements, the market today seems to be just right for these funds. As Steve Braverman, co-chair of Pathstone in Scottsdale, Ariz., puts it, “The covered-call strategy is certainly more attractive now than [it was] when markets were one-directional.”