Covered Calls: What People (Still) Get Wrong

Key Concepts

• Covered Calls: A strategy where an investor owns an underlying asset (like stocks) and sells call options on that asset. The goal is to generate income from the option premiums.
• Actively Managed Mutual Funds: Funds where a portfolio manager makes investment decisions to try and outperform a benchmark index. These often have higher fees.
• Index Funds: Funds that aim to replicate the performance of a specific market index (e.g., S&P 500). They typically have lower fees.
• Yield: The income generated by an investment, often expressed as a percentage of the investment's value.
• Option Premiums: The income received by the seller of an option contract.
• Upside Participation: The ability of an investment to benefit from the growth of the underlying asset's price.
• Downside Protection: The ability of an investment to mitigate losses during market downturns.
• Mental Accounting Bias: The tendency for people to treat money differently depending on its source or intended use, often leading to suboptimal financial decisions.
• Leverage: Using borrowed money to increase the potential return (and risk) of an investment.

Covered Calls and Market Downturns

• Argument: Covered calls offer some protection in a downturn due to option premiums, but this protection is temporary and comes at the cost of limiting upside participation during recovery.
• Evidence:
  • The Invesco S&P 500 buy ETF (a covered call fund) launched in December 2007, just before the Great Financial Crisis.
  • A comparison showed that while the covered call fund slightly reduced downside during the crisis, an investor in a simple S&P 500 index fund would have accumulated 3.88 times more wealth by September 2025, assuming constant spending from both portfolios based on the covered call fund's distributions.
  • The option premiums act as a buffer when stocks are down, but writing those options into an eventual recovery is destructive to wealth because they limit upside participation.
• Key Point: The number of shares multiplied by the price is what matters for wealth accumulation. Covered calls can cap upside, leading to less wealth overall, even if they help avoid selling shares in a downturn.
• Technical Term: Distribution Yield: The income paid out by a fund, often used to fund spending. In the examples, spending was matched to this yield.

Comparison of Covered Call Funds vs. Underlying Equities

• Argument: Many new covered call funds, despite claims of superiority, underperform their underlying equities over the long term.
• Examples and Data:
  • SPYI (NEOS S&P 500 High Income ETF): Trailed Vanguard 500 index fund by 4.61% annualized since August 2022.
  • QQQI (NEOS NASDAQ 100 High Income ETF): Trailed Invesco NASDAQ 100 ETF by 2% annualized since January 2024.
  • JPQ (JPMorgan Equity Premium Income ETF): Trailed Invesco NASDAQ 100 ETF by 4.36% annualized since May 2022. While it did better than its underlying in the 2022 downturn, the advantage was short-lived.
  • DIVO (Amplify CWP Enhanced Dividend Income ETF): Compared to Vanguard Dividend Appreciation Index Fund ETF, DIVO underperformed by 51 basis points annualized since December 2016. It performed even worse against an S&P 500 benchmark.
  • HYLD (Hamilton Enhanced US Covered Call ETF): Underperformed an S&P 500 ETF hedged to CAD by 0.9% annualized since February 2022, despite a modest 25% cash leverage.
  • HDIV (Hamilton Enhanced Multi-Sector Covered Call ETF): While it beat the S&P TSX60 (its stated benchmark), this was achieved with 25% leverage and a portfolio mix that differed from the benchmark. A reconstructed model without leverage and with a proper benchmark outperformed HDIV. The speaker cautions against short-term performance and emphasizes the overwhelming evidence against active management's long-term outperformance.
  • HHIS (Harvest Diversified High Income Shares ETF): This fund, with 25% leverage and a concentrated portfolio of 15 trending companies, performed similarly to its underlying stocks without leverage. When 25% leverage was applied to the underlying stocks, it significantly outperformed HHIS, isolating the negative effect of covered calls.
• Key Point: The performance of these funds often fails to justify their higher fees and the complexity of the covered call strategy.

The Role of Unlicensed Financial Content Creators

• Argument: The promotion of high-fee products like covered call funds by unlicensed content creators is risky and exploits investor biases.
• Details:
  • A "cottage industry" of unlicensed creators promotes these products, often selling access to coaching or research.
  • Financial advice is regulated for a reason, and taking advice from unregulated creators with limited financial backgrounds is dangerous.
  • These creators often sell "hope" and a "better future" without investors understanding the true costs.
• Quote: "Capitalists respond to the actual demand for their products, not the demand that would exist if people were perfectly rational and truly understood their own best interests. Since people's demands are driven by the benefits they perceive rather than the benefits they actually get, the financial system supplies too many products with exaggerated benefits and too few products with underappreciated benefits. And since perceived costs rather than actual costs drive people's demands, the financial system supplies too many products with hidden costs." - John Campbell, Fixed.
• Key Point: Capitalism can fail when consumers don't understand product benefits or costs, leading to the supply of products with exaggerated benefits and hidden costs.

Why Ben Felix Continues to Discuss Covered Calls

• Personal Responsibility: Felix feels a responsibility to address the significant discussion and potential errors in investor assessments of these products, especially with their proliferation in Canada.
• Professional Role: Understanding complex financial products is a core part of his job as Chief Investment Officer at PWL Capital. Making videos helps him assess and strengthen his knowledge.
• Altruistic Motivation: He wants to see a financial product marketplace in Canada that is less overwhelming, intimidating, and dangerous for new investors.
• Addressing Investor Biases: Covered calls are a challenging example because they cater to the strong mental accounting bias, making it difficult for investors to see the true costs.
• Goal: To provide fundamental information and basic performance comparisons to help people make better decisions or ask the right questions.

Synthesis and Conclusion

Ben Felix argues that covered call funds, despite their appeal for income generation and perceived downside protection, are ultimately destructive to long-term wealth accumulation. He highlights that the option premiums generated by selling calls provide only a temporary buffer in downturns and significantly limit upside participation during market recoveries, leading to substantially lower overall wealth compared to simple index funds. Felix criticizes the proliferation of these high-fee products, often promoted by unlicensed content creators, which exploit investor biases like the desire for income and mental accounting. He provides detailed performance comparisons of various covered call ETFs against their underlying benchmarks, demonstrating consistent underperformance. Felix concludes that his continued discussion of this topic stems from a personal responsibility to educate investors, a professional need to deepen his understanding, and a desire to foster a safer and more transparent financial marketplace in Canada. He emphasizes that covered calls change the distribution of expected returns in a detrimental way for long-term investors and are not a "free lunch."