In the last few years, covered call ETFs has become very popular with income-focused investors. The industry is now worth over 80 billion dollars.
JPMorgan Equity premium Income ETF leads with more than $33 billion. The JPMorgan Nasdaq Equity premium Income ETF (JEPQ) is the second largest with over $14 billion.
Global X S&P500 Covered call ETF and Global X NASDAQ 100 covered call ETF are also among the top ETFs. They have respectively added $7.9 and $2.83 Billion in assets.
Covered call ETFs are becoming popular
Two main factors have made covered call ETFs very popular with investors. They are well-known for their high yields, which can be as much as double digits, and they beat out other dividend ETFs such the Schwab US Equity Dividend (SCHD) by a wide margin.
JEPI has a yield of 7.32%, while JEPQ yields 9.7%. QYLD has a yield of 12%, while XYLD is at 9,58%. The Federal Reserve could start reducing interest rates, making these yields more attractive.
As expectations for rate reductions rise, US bonds yields are starting to fall. The 10-year yield was 3.90%, while the 30-year rate moved up to 4.22%. They were above 5% just a few short months ago.
These covered call ETFs have also become popular because they are a great way to hedge volatility. Most investors think that they’ll do well even if the indexes accompanying them decline sharply.
The way these funds are constructed, they aim to do just that. The funds sell derivatives that generate income tied to an underlying asset in the first phase.
This is a simple idea. First, the ETF will gain from the long trade when the asset’s trend is upward. The ETF also benefits because the option part of the trade provides protection and income.
As an example, suppose that a particular asset is trading for $10. You place a trade at $11.5 as a call. The call trade allows you to purchase an asset, but does not obligate you to do so. You won’t exercise the option if it falls to $9 because you could buy it on the open market for a lower price.
You can exercise the option to take profit if the price of the stock rises above $11. Your gains are capped at 11, so if the stock rises above $12, you will lose out on your trade. These funds generate income by selling call options, and they then distribute it to their investors.
JEPI JEPQ QYLD are behind the market
I’ve written that covered call ETFs, which are newer, underperform the assets they represent. JEPI underperformed S&P 500 while covered call ETFs that hold single stocks like TSLY or NVDA underperformed Tesla, Nvidia and Nvidia respectively.
These funds, despite the high dividend yields they advertise, have not kept pace with benchmark assets. JEPI has a higher dividend yield of 7.5% than ETFs which track S&P 500 indices such as the VOO or SPY.
Second, on Monday the American stock market plunged as fears grew over the Japanese carry trade ending. These funds would have performed better than the S&P 500 or the Nasdaq 100 in this instance.
Data shows, however, that the outperformance of these options was very minimal. This performance was due to the fact that the gains made in the option market were not enough to compensate for the steep decline of stocks.
The JEPI ETF fell by 2,8% on Monday. This was slightly less than the S&P 500’s 3%. Other covered call ETFs also showed the same pattern. An analyst wrote to the FT in a letter that:
“These funds don’t like volatility. It’s a strategy that they call income, but you are really just selling volatility. This can be profitable for a long time, but it can also get blown out of the water when there is a major crash.
S&P500 vs JEPI ETF
In 2022, this view was confirmed when the JEPI ETF performed better than the S&P 500 by a greater margin. The index fell by 20 percent between the first of January and the 31st December. JEPI dropped by a more modest 2.5%.
This was also the case with the Nasdaq 100 Index, which fell by 26%. The JEPQ ETF dropped 12%.
Investors should be aware that they cannot expect to see a return on their investments when indices are in decline.
As shown in the chart above, these covered call returns have underperformed market performance by a wide margin. On this graph, the JEPI ETF and XYLD have risen 19.4% and 10.70% respectively. The basic SPY, however, has risen 26%.
Invesco QQQ has also risen 24.5%. JEPQ had a better total return than QQQ, at 28%. Morningstar’s analyst confirmed this view:
I always say that as a long-term investment, this is not an option. “You’re giving away a lot in terms of potential upside. And compounded on a long-term basis, this is not a great proposition.”
The post ETFs XYLD and QYLD have failed two key tests, which JEPI, JEQ, XYLD and JEPQ all failed, may change as new information becomes available.
