Covered Calls: What People Get Wrong

Covered calls are generally detrimental to long-term wealth, even for income generation, because they significantly cap upside participation and reduce expected returns, leading to lower sustainable spending despite perceived short-term benefits in down markets.

• Covered calls reduce expected returns and long-term wealth despite perceived income benefits.

• While offering minor downside protection, covered calls cap upside, leading to significant underperformance in recovering markets.

• Investors are urged to scrutinize 'yields' and hidden costs, choosing low-cost index funds for superior long-term outcomes.

Covered call funds are widely promoted, often by unlicensed content creators, and appeal to investors seeking income and perceived protection, but they come with significant hidden costs and ultimately reduce long-term wealth. Despite offering a small buffer in falling markets by generating option premiums, these funds limit upside during market recoveries, leading to substantial underperformance compared to underlying equity indexes over time. Investors are often misled by 'yields' that do not equate to actual returns and are urged to understand the true impact of these products on their portfolios.

Misleading Financial Products

• 00:00:47 The financial product landscape has seen a resurgence of high-fee products, similar to actively managed mutual funds, that are now being promoted by unlicensed content creators. These products, including covered call funds, exploit investor biases by exaggerating benefits like 'income' while obscuring true costs, leading people to demand products that are not in their best long-term interest, as highlighted by John Campbell's insights on capitalist responses to perceived demand.

• 00:03:05 Financial markets and advice are regulated for a reason, and while regulation in Canada has had its flaws with high-fee funds, taking advice from unregulated content creators with limited financial backgrounds on products like covered calls is inherently risky. The primary issue with covered calls is their marketing based on 'yields' as if they represent returns, when in reality, these yields are at best irrelevant and more likely have a negative relationship with expected returns.

Covered Calls in Downturns

• 00:03:40 Covered calls offer some protection in a falling market by generating option premiums, which can create a small buffer. However, historical analysis, including the Great Financial Crisis and the 2022 downturn, shows that while covered calls might slightly reduce initial losses, they quickly fall behind as equities recover due to limiting upside participation. For example, an investor in a covered call strategy would have significantly less wealth than one in an underlying equity fund over the long term, even when spending is held constant.

• 00:07:20 The perception that covered calls avoid selling shares in a downturn is misleading; while they might prevent selling shares, they cap potential upside, resulting in less overall wealth. The strategy resembles holding a large portion of a portfolio in cash, which can appear favorable during stock market declines but proves very expensive in the long run by significantly reducing expected returns and thus, the ability to fund future expenses.

Underperformance of Covered Call Funds

• 00:09:11 Many investors mistakenly believe that specific covered call funds outperform, but rigorous analysis consistently shows them trailing their underlying equities, even for highly touted examples like SPYI, QQQI, JEPQ, and DIVO. These funds generally underperform their appropriate benchmarks by annual percentages ranging from 0.51% to over 4%, with any short-term advantage in downturns quickly negated by the inability to participate fully in subsequent market recoveries.

• 00:11:26 Even Canadian-listed leveraged covered call ETFs like HYLD and HDIV, which boast specific sector mixes, exhibit similar underperformance when properly benchmarked and adjusted for leverage. Short-term performance of concentrated, actively managed portfolios like HHIS, while sometimes appearing to beat broad indexes, is generally unsustainable in the long run, as the vast majority of active managers consistently underperform index funds, indicating that covered calls fundamentally alter the distribution of returns to the detriment of long-term investors.

The Speaker's Motivation

• 00:14:51 Ben Felix, Chief Investment Officer at PWL Capital, continues to discuss covered calls not for personal gain or product promotion, as he advocates for low-cost total market index funds. His motivation stems from his professional responsibility to understand complex financial products and to strengthen his own knowledge through public discourse.

• 00:15:30 More altruistically, he aims to contribute to a less intimidating and dangerous financial product marketplace in Canada, helping investors navigate confusing marketing and make better decisions. Covered calls are a particularly challenging example because they cater to strong mental accounting biases, and by providing factual information and performance comparisons, he hopes to empower individuals to ask the right questions and make informed choices.