Was I Wrong About Covered Calls?

Here's a comprehensive summary of the YouTube video transcript, maintaining the original language and technical precision:

Key Concepts

• Covered Call: A strategy where an investor sells call options on a stock they already own.
• Call Option: A contract giving the buyer the right, but not the obligation, to purchase an underlying asset at a specified price (strike price) on or before a certain date.
• Strike Price: The predetermined price at which the underlying asset can be bought or sold.
• Premium: The price paid by the buyer of an option to the seller.
• Distribution Yield: The income generated by a fund, often from option premiums, distributed to investors.
• Total Return: The overall gain or loss of an investment, including capital appreciation and income.
• Upside Cap: The limitation on potential gains when selling a covered call.
• Downside Risk: The potential for losses in an investment.
• Mean Reversion: The tendency for stock returns to revert to their historical average over time.
• Leverage: The use of borrowed funds to increase the potential return of an investment.
• Mental Accounting Bias: The tendency to treat money differently depending on its source or intended use.
• Fiduciary Duty: A legal or ethical relationship of trust between two or more parties, where one party is obligated to act in the best interests of the other.

Covered Calls: A Financial Illusion

This video argues that covered call funds, despite their attractive distribution yields, are detrimental to long-term investors, including those seeking income. The presenter, Ben Felix, Chief Investment Officer at PWL Capital, explains that these products create an illusion of income while systematically lowering expected total returns and increasing risk.

Background on Covered Calls

A covered call strategy involves selling a call option on a stock the investor already owns. This grants the buyer the right to purchase the stock at a predetermined strike price in exchange for a premium.

• Mechanism: If the stock price stays below the strike price plus the premium, the option expires worthless, and the investor keeps the premium, slightly outperforming holding the stock.
• Upside Cap: If the stock price rises above the strike price, the option is exercised, and the investor must sell their stock at the strike price, capping their potential gains. The maximum profit is the strike price plus the premium.
• Downside Risk: On the downside, the premium offers minimal protection, and the investor still bears nearly the full price decline of the shares.

Funds employing this strategy distribute the option premiums, leading to high distribution yields. However, these yields are misleading because they come at the cost of capped upside returns.

Live Fund Examples and Performance Comparisons

The video presents data from several covered call ETFs compared to their underlying equity ETFs, assuming reinvestment of distributions.

• Global X S&P 500 Covered Call ETF vs. iShares Core S&P 500 ETF: The covered call ETF has underperformed by an annualized 3.15% since January 2014.
• Global X S&P TSX 60 Covered Call ETF vs. iShares S&P TSX 60 ETF: The covered call ETF has underperformed by an annualized 3.81% since March 2011.
• BMO Covered Call Canadian Banks ETF vs. BMO Equal Weight Banks ETF: The covered call ETF has underperformed by an annualized 2.86% since February 2011.

Portfolio Withdrawal Analysis: Income vs. Total Return

A crucial point addressed is whether total returns are the right metric for income-oriented investors. The presenter models a 10-year withdrawal scenario for five pairs of funds, where an investor in the covered call fund spends approximately the fund's distributions, and an investor in the underlying equity fund spends the same dollar amount through a combination of dividends and selling shares.

• Key Finding: In all cases, the investor in the underlying equities had a higher ending portfolio value after 10 years, with an average of 26% more capital remaining. This demonstrates that the total return is what matters for funding consumption, and it is possible to spend from the capital portion of a portfolio sustainably.
• Mental Accounting Bias: The belief that one cannot spend from capital is identified as a mental accounting bias.
• Implied Cost: To achieve equal ending wealth outcomes, the break-even fee for investing in the underlying equity funds would range from 1.5% to 2.7%, illustrating the substantial cost of the covered call strategy.
• Cash Allocation Equivalence: Alternatively, holding a cash allocation (in a high-interest savings account) of 19% to 36% alongside the underlying equities would yield similar ending wealth outcomes as covered call funds, while reducing downside risk exposure. This highlights that covered calls reduce upside exposure without providing significant downside protection.

Broader Sample of Canadian Covered Call ETFs

A sample of 20 Canadian listed covered call ETFs was analyzed against comparable underlying equity ETFs.

• Methodology: Total return comparisons were used due to shorter time series data. Funds with niche sectors, concentrated portfolios, or active management were excluded where possible.
• Results: On average, covered call ETFs underperformed comparable underlying equity funds by an annualized 3.25%, with a median underperformance of 2.96%. Only two technology-focused covered call funds with short histories and imperfectly matched underlying portfolios outperformed.
• Additional Risk: Many covered call products are niche sector funds with concentrated, actively managed portfolios, adding further risk beyond the covered call strategy itself.

Enhanced Covered Call Funds and Leverage

Enhanced covered call funds combine the covered call strategy with leverage to increase yield and expected returns.

• Global X Index Series Example: Across five index funds, enhanced covered call funds performed above regular covered call funds but below the underlying equities during periods of positive returns. They also experienced more severe drawdowns during negative periods.
• Leverage Impact: Leverage boosts returns in good times and amplifies losses in bad times.
• Recommendation: If an investor is comfortable with higher volatility and leverage, leveraging the underlying equity directly is generally a better option. In all five example funds, the leveraged version of the underlying equity outperformed the covered call and leveraged covered call funds.

Professional Perspective and Information Incentives

Ben Felix addresses whether he, as a financial professional, feels threatened by covered call funds. He states that wealth management encompasses more than just income generation, including goal setting, asset allocation, cash flow planning, insurance, product allocation, and tax awareness. Covered calls only marginally address cash flow planning.

• Information Source Conflicts: A significant concern is the source of information promoting covered calls. Many content creators are sponsored by companies selling covered call ETFs, creating a conflict of interest.
• PWL Capital's Stance: PWL Capital, as a wealth management firm and fiduciary, does not use covered call ETFs because they are considered detrimental to investors. While they have a business interest in clients delegating portfolio management, they have no financial stake in specific product choices like covered call ETFs.
• Investor Caution: Investors are urged to understand what they are investing in, the implied costs, and the incentives of their information sources.

Conclusion

Covered call funds create the illusion of passive income through high distribution yields but come with significant costs: capped upside returns and no meaningful downside protection. This leads to lower total returns compared to simply holding the underlying equities. For investors seeking income, creating it themselves through dividends and judicious selling of shares is a more effective and less costly strategy. The complexity and potential for conflicts of interest surrounding these products warrant careful scrutiny by investors.