Was I Wrong About Covered Calls?

Covered call funds are generally detrimental to long-term investors, including those needing income, because they cap upside returns, offer minimal downside protection, and systematically lower expected total returns despite high distribution yields.

• Covered call funds generally lead to lower total returns by capping upside and offering limited downside protection.

• The high distribution yields of covered call funds create an illusion of income but come with substantial implied costs.

• Creating your own income stream from an equity portfolio (dividends plus share sales) typically yields better outcomes than investing in covered call funds.

Covered call funds are often marketed as a source of passive income but systematically underperform underlying equities over the long term. These funds create an illusion of income while capping upside potential and offering insufficient downside protection, resulting in lower total returns and higher implied costs for investors. This underperformance holds true for both wealth accumulation and withdrawal scenarios, contrary to popular belief that they benefit income-oriented investors.

Understanding Covered Calls

• 00:01:40 Selling a call option means granting someone the right to buy your stock at a predetermined strike price in exchange for a premium. While this premium provides a small benefit if the stock stays below the strike price, it caps your upside potential if the stock price rises significantly, as the fund must sell shares below market value. Downside risk remains largely unchanged from simply owning the stock, as the premium only slightly softens the blow of significant price declines.

Performance Analysis & Impact

• 00:04:37 Empirical data consistently shows that covered call ETFs significantly trail their comparable underlying equity funds, with average underperformance around 3% annually. This underperformance affects both investors accumulating wealth and those drawing income from their portfolios. Even when accounting for monthly withdrawals, covered call funds result in substantially less capital after 10 years compared to managing a traditional equity portfolio through a combination of dividends and share sales.

The High Implied Cost

• 00:07:26 The strategy of covered calls carries a substantial implied cost, comparable to paying a non-tax-deductible fee of 1.5% to 2.7% annually when compared to simply holding the underlying equity. Alternatively, to achieve similar ending wealth outcomes with underlying equities, an investor would need to hold a significant cash allocation, ranging from 19% to 36% of their portfolio, highlighting how covered calls reduce equity exposure but without the downside protection of actual cash holdings.

Enhanced Funds & Conflicts of Interest

• 00:11:35 Enhanced covered call funds, which use leverage, typically outperform regular covered call funds in positive markets but exacerbate drawdowns during downturns; however, a leveraged version of the underlying equity without covered calls generally yields superior returns. Furthermore, much of the promotional content for covered call funds is sponsored by the companies selling these ETFs, creating a conflict of interest that investors should be aware of when seeking financial information.