Covered Call Funds – A Stupid Idea

Recently my spam filter caught an email extolling the virtues of covered call funds. I have been aware of these sorts of funds for a while but have never paid them much attention for reasons that will become apparent in this piece. The website I referenced defines a covered call ETF as the following –

A covered call strategy involves buying a stock or basket of stocks and selling a call option on those securities. Selling a call option forfeits the upside potential on those underlying stocks if it’s written at-the-money (ATM). In exchange, the investor receives a premium for selling the call option. Therefore, a covered call strategy can be used to generate additional income from equities.

Whenever you undertake any form of trading strategy you need to ask the question, does the strategy or technique add value in some way to the trader? This is particularly true when you introduce a level of complexity to a trading system such as writing covered calls. Complexity needs to generate a payoff over and above what could be achieved by a much simpler strategy. Fortunately, it is easy to see whether complexity adds value in terms of generating a higher return when comparing trading ideas.

When I looked through the marketing material provided for these ETFs they referred to their ASX variants which unfortunately had very little data from which to generate a comparison. However, there were analogous funds listed in the US from which I was able to extract a decade’s worth of data. For my comparison, I used Global X S&P 500 Covered Call ETF (XYLD) and compared it to SPY

My first task was to get a sense of the performance of XYLD over the long term – the chart below shows the value of $1 invested in XYLD. I have broken this down into the price only and the total return.

This chart doesn’t really convey all that much, it should be expected that any comparison comparing price only and total returns would look like the chart above.

The central question is does writing covered calls over the index generate an outsized return above simply holding an equivalent ETF? In the chart below I have compared the total return from XYLD to SPY.

In a simple head-to-head competition of which one makes the most money for investors over the long term, the answer is that it is no contest – simply holding SPY and reinvesting the dividends beats holding XYLD and reinvesting its dividends. However, it should be remembered that XYLD is marketed as a yield-based investment so I decided to have a look at the raw income component of the total return for each vehicle.

The expectation would be that the income based component of XYLD would trounce that of SPY but that doesn’t seem to be the case. This raises the question as to why the performance of XYLD is so poor when compared to the underlying index and the answer to this should be obvious to anyone who knows anything about options the answer can be found in the highlighted section of the following quote –

A covered call strategy involves buying a stock or basket of stocks and selling a call option on those securities. Selling a call option forfeits the upside potential on those underlying stocks if it’s written at-the-money (ATM). In exchange, the investor receives a premium for selling the call option. Therefore, a covered call strategy can be used to generate additional income from equities.

The first rule of selling options is that you write out of the money options so as to give yourself room to move and not adversely impact your holding of the underlying by risking either preemptive exercise or having to buy the options back at a loss. If we look at the trend of the S&P500 for the past decade we get an idea of why simply holding the underlying ETF was a much better strategy.

The overall trend for the market has been bullish and the act of writing ATM calls in such an environment almost guarantees underperformance either through missing out on the potential upside of the index or having to buy back your options at a loss.