Covered Call ETFs vs. Dividend Growth: Gary Gambino Explains DGRO and DIVO

Key Concepts

• Covered Call ETFs
• Total Return
• Dividend Growth ETFs
• Expense Ratios
• Diversification
• Tax Implications (Qualified Dividends, Ordinary Income, Return of Capital)
• Bull Market vs. Bear Market Performance
• Option Premium

ETF Spotlight: A Comparative Analysis of Income-Focused ETFs vs. Covered Call ETFs

This episode of ETF Spotlight features Seeking Alpha analyst Gary Gambino, who discusses his perspective on covered call ETFs and introduces two alternative income-focused ETFs, DGRO and DIVO, that he argues may offer better value to investors.

Gary Gambino's Perspective on Covered Call ETFs

Gary Gambino's primary investment focus is maximizing total return. He observes that, over time, covered call ETFs tend to generate slightly less total return compared to generic index ETFs. While acknowledging that retirees or individuals needing extra income might make a conscious trade-off to sacrifice some total return for additional income, he suggests that even within covered call ETFs, some are managed better than others. His preference, if income is not a primary necessity, is to opt for an index ETF over generating extra income through covered calls.

Reasons for lower total return in covered call ETFs:

1. Higher Expense Ratios: The active management involved in selling calls and managing the strategy incurs higher fees.
2. Capped Upside in Bull Markets: Selling covered calls limits potential gains when the underlying assets experience strong upward price movements, as these assets may be "called away" (sold at the strike price). This sacrifices upside potential in exchange for income.

Alternative Income-Focused ETFs: DGRO and DIVO

Gary Gambino highlights two ETFs, DGRO and DIVO, as potentially more attractive options for investors seeking income.

DGRO: Dividend Growth ETF

• Nature: A passively managed index ETF focused on dividend growth.
• Index Construction Rules:
  • Excludes REITs and the top 10% of highest yielders, which are often more susceptible to dividend cuts during economic downturns.
  • Requires underlying companies to have a minimum 5-year history of dividend growth.
  • Mandates a payout ratio (dividends divided by income) of less than 70%, indicating companies are not over-extending themselves and are more likely to sustain and grow dividends.
• Performance: Tends to hold up better in bear markets compared to simple S&P 500 index ETFs (like SPY) due to the quality of its holdings, though it may slightly underperform on the upside.
• Expense Ratio: A very low 8 basis points.
• Holdings: Over 405 holdings, including names like Apple, Home Depot, Broadcom, Procter & Gamble, and UnitedHealth.
• Tax Implications: Generally offers qualified dividends, which are taxed at lower rates.

DIVO: Covered Call ETF with a Limited Strategy

• Nature: A covered call ETF that employs a selective strategy.
• Strategy: Selectively sells calls against certain positions rather than the entire index or portfolio.
• Income Generation: Generates approximately 4.5% yield, compared to DGRO's 2.5%.
• Total Return: Over time, DIVO's total returns have been comparable to DGRO, suggesting investors are not sacrificing significant total return for the extra income.
• Expense Ratio: Approximately 56 basis points, reflecting active management of both the stock portfolio and covered call sales.
• Holdings: 34 holdings, including names like RTX Corp, Apple, Visa, Microsoft, JP Morgan, Goldman Sachs, and Home Depot.
• Tax Implications: A mixed bag, with distributions potentially being qualified dividends, non-qualified dividends, or return of capital. Investors need to examine the fund's strategy and historical distributions to understand the tax impact. Return of capital lowers the cost basis, deferring taxes but increasing future tax liability upon sale.

Diversification and Holdings

Gary Gambino views diversification as important, but notes diminishing returns beyond a certain point. He observes that DIVO, despite having fewer holdings than DGRO, has tracked DGRO's total return closely, suggesting its level of diversification is sufficient. DGRO offers more diversification than likely necessary, but it doesn't detract from its performance.

Investor Suitability: DGRO vs. DIVO

• For those needing income: DIVO is a suitable option, as it provides extra income with a relatively small sacrifice in total return and a well-managed covered call strategy.
• For younger investors or those reinvesting dividends: DGRO is the preferred choice. Gambino advises against reinvesting dividends in covered call funds, suggesting index funds are more appropriate for this strategy.
• Market Outlook:
  • Bear Markets: Both DGRO and DIVO tend to hold up better than the S&P 500. DIVO may even hold up slightly better due to the option premium received from call sales, which can offset some of the downside.
  • Bull Markets: Investors anticipating a strong bull market should avoid covered call funds like DIVO due to the risk of their holdings being called away.

Research Methodology on Seeking Alpha

Gary Gambino discovers ETFs like these by noticing covered call ETFs trending on Seeking Alpha's front page. He then analyzes their total returns over various periods (including up and down markets), compares their holdings to comparable index ETFs, and trends their performance against each other.

Tax Implications

• DGRO (and most index funds): Primarily offers qualified dividends, taxed at lower rates.
• Covered Call ETFs (like DIVO): Can have a mix of qualified dividends, non-qualified dividends, and return of capital. Investors must investigate the specific fund's distribution strategy to understand the tax consequences, particularly regarding return of capital which defers taxes but lowers cost basis.

Biggest Risk in Covered Call ETFs

The most significant risk that investors often misunderstand about covered call ETFs is the illusion of getting something for nothing. Investors are drawn to the higher yield but fail to fully grasp that they are:

• Giving up upside potential in strong bull markets.
• Receiving only limited downside protection in bear markets from the option premium, without actual hedging mechanisms.

While covered call ETFs may offer lower volatility, this is often a result of capping upside rather than true downside protection. Gambino emphasizes that the extra income is not free and comes with trade-offs in total return.