3 Ways Covered Call ETFs Outperform Index Investments

Covered ETFs are increasingly popular in today’s market climate because they allow investors to take advantage of market volatility while generating income that surpasses even high-yield savings accounts. Covered calls are an options strategy where an investor holds shares of a stock or ETF such as SPDR S&P 500 ETF (NYSEARCA:A SPY) and sells calls against their shares. Covered calls are a popular strategy for options traders, but they have critical limitations for many retail investors.

First, you will need to have at least 100 shares to sell calls against the asset. This can be expensive as just 100 shares of SPY will set you back at least $42,000 today. Second, covered calls come with the risk of porting. This means you are forced to sell the stock if the option expires “in the money”. Buying and selling stocks to support a covered call strategy can be time-consuming and have unexpected tax consequences. This is where covered call ETFs shine.

Investors have flooded one popular ETF with more than $10 billion this year alone, highlighting another important point. While long-term wisdom dictates a buy-and-hold index investing strategy, covered ETFs have key advantages over that strategy in today’s market.

Covered-Call ETFs reduce volatility

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Today, the most popular covered call ETF, the JPMorgan Equity Premium Income ETF (NYSEARCA:OFTEN), is surprisingly stable compared to indices today. JEPI owns shares of S&P 500 stocks and “out-of-the-money” puts covered calls against the income-generating assets. While the focus of investors is usually on the income opportunities, reduced volatility is a hidden benefit.

In 2022, when stocks tumbled worse than we’ve seen in recent weeks, the S&P 500 lost a collective 18%. JEPI’s share price fell just 3.5%. In this sense, the JEPI serves as a proxy for the volatility-reduced index itself. The covered call ETF protected investors’ portfolios from the worst market shocks.

Covered-Call ETFs generate income

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Of course, the opportunity for income is the most popular benefit of covered ETFs. Growth indices such as the S&P 500 or NASDAQ 100 usually do not generate a high dividend yield. SPY, for example, has returned just 1.52% over the past twelve months. On the other hand, covered call ETFs like Global X NASDAQ 100 Covered Call ETF (NASDAQ:QYLD) yielded a whopping 12.14% over the same period.

QYLD’s prospectus tells investors it intends to “produce higher returns in times of volatility.” Likewise, JEPI’s trailing-year yield stands at a respectable 11.04%, especially considering QYLD’s higher expense ratio of 0.60%, or $60 per year on a $10,000 investment. The best part of the yield from high dividends is that they are distributed monthly, providing a constant cash flow. At the same time, most covered call ETFs are priced well below their index investment ETF counterparts. QYLD, for example, is worth just $17 per share. For the same price as 100 shares of SPY, you can buy almost 2,500 shares of QYLD. Run through the distribution numbers and you’re entitled to $0.172 per share – more than $400 per month! Combine a huge yield that beats boring bonds with reduced volatility, and covered ETFs are ideal in light of continued bearish sentiment.

Covered-Call ETFs help offset losses

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This benefit for covered call ETFs closely reflects the opportunity for reduced volatility, with a key caveat. Covered ETFs are less volatile as a stand-alone investment. At the same time, they can also help offset losses if you hold the underlying index.

Like QYLD, the JPMorgan Nasdaq Equity Premium Income ETF (NASDAQ:JEPQ) is a covered call ETF put option against the NASDAQ 100 with an expense ratio of 0.35%, or $35 per year on a $10,000 investment. As on Morningstar according to the analysis, this covered-call ETF “provides attractive income by giving up the upside of its high-growth index.” While this may seem like a disadvantage, consider what would happen if you held JEPQ alongside a NASDAQ 100 ETF like Invesco QQQ Trust (NASDAQ:QQQ).

Over the past 3 months, QQQ has fallen by nearly 7%. During the same period, JEPQ’s share price remained slightly more stable due to reduced volatility, falling only 4.75%. But with the dividend distribution included, the covered-call ETF fell just 2%. If you own QQQ but can’t afford enough stock to execute your own covered call strategy, owning JEPQ along with it would balance out your losses significantly.

The best part? Since JEPQ distributes dividends on a monthly basis, you can easily use this cash flow to buy more shares of QQQ, creating a feedback loop and a self-sustaining dollar cost averaging strategy. This positions you for an eventual market recovery as you can put more money into a down index instead of letting inflation eat away at your money!

As of the date of publication, Jeremy Flint had no positions in the securities mentioned. The opinions expressed in this article are those of the author, subject to InvestorPlace.com Publishing Guidelines.

Jeremy Flynt, an MBA graduate and seasoned financial writer, excels at content strategy for wealth managers and investment funds. Passionate about simplifying complex market concepts, he focuses on fixed income investments, alternative investments, economic analysis and the oil, gas and utilities sectors. Jeremy’s work can also be found at www.jeremyflint.work.

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