Ben Felix Explains Why Covered Calls Are Detrimental to Long-Term Investors

Ben Felix

Introduction & Motivation [0:00]

• The speaker, Ben Felix, decided to create another video on covered calls after observing their widespread promotion at a retail investor conference and frequent inquiries about them.
  • He notes a strong push for covered call funds and did not realize the extent of their prevalence in the market.
• He states that these products are likely to be detrimental to long-term investors, including those requiring income.
• The goal is to articulate the truth about what covered call funds should be expected to do in an understandable manner.

What is a Covered Call? [0:01:38]

• A covered call involves selling someone the right to buy a stock from you at a predetermined strike price in exchange for a premium.
  • Example Scenario:
    • Stock trading at $100.
    • Sell a call option with a strike price of $105.
    • Collect a $2 premium.
  • Effect on Returns:
    • If the stock stays below $105: The option expires worthless, you keep the $2 premium, slightly outperforming just holding the stock (as long as the stock stays above $98, which is $100 - $2 premium).
    • If the stock rises above $105: The option is exercised. Your upside is capped at the strike price ($105). You make $5 from the stock increase plus the $2 premium, for a maximum profit of $7.
      • You are ahead compared to holding the stock as long as the price stays below $107 ($105 strike + $2 premium).
      • If the price climbs past $107, you would have been better off without the covered call.
    • If the stock crashes (e.g., to $50): You still pocket the $2 premium, but you incur nearly the full loss from the stock's price decline. The premium only slightly softens the blow.
      • Your downside risk remains mostly unchanged from simply owning the stock.
• Funds using this strategy typically distribute option premiums as income, leading to high distribution yields.
  • These high yields are often misleading because selling calls reduces exposure to underlying equity primarily on the upside, while downside exposure remains largely intact.
  • This caps the ability of the fund to recover after market downturns, reducing expected returns.

    

• Covered call funds are not good investments for long-term investors.
  • They do not generate true passive income.
  • They create unnecessary layers of risk and cost.
  • They create the illusion of income while systematically lowering expected returns and increasing risk by changing the distribution of returns.

Performance Comparisons with Reinvested Distributions [0:03:37]

• The previous performance comparisons assumed the reinvestment of distributions. This video also uses the same assumption, which is critical due to the high yields.
• 1. Global X S&P 500 Covered Call ETF vs. iShares Core S&P 500 ETF [0:04:38]
  • The covered call ETF trailed its underlying index by an annualized 3.15 percentage points since January 2014.
• 2. Global X S&P TSX 60 Covered Call ETF vs. iShares S&P TSX 60 ETF [0:04:48]
  • The covered call ETF trailed its underlying index by an annualized 3.81 percentage points since March 2011.
• 3. BMO Covered Call Canadian Banks ETF vs. BMO Equal Weight Banks ETF [0:05:00]
  • The covered call ETF trailed its underlying index by an annualized 2.86 percentage points since February 2011.

    

Withdrawal Analysis: Matched Spending for Income [0:05:09]

• This analysis addresses whether covered calls perform better for income-oriented investors who need to withdraw funds monthly.
• The model uses 10 years of data for five pairs of funds (covered call fund vs. underlying equity fund).
• In the model:
  • The covered call fund investor spends approximately the fund's distributions.
  • The underlying equity investor spends the same dollar amount each month, generated by a combination of portfolio dividends and selling shares.
  • Both investors spend the exact same dollar amount monthly.
• Mental Accounting Bias [0:06:27]
  • The belief that returns must come from "income" rather than "capital" is a mental accounting bias.
  • It is possible to sustainably spend from the capital portion of a portfolio.
  • This bias can be very costly to investors.

    

• Results of Withdrawal Analysis [0:06:52]
  • Not one of the covered call funds had higher ending wealth after 10 years compared to its comparable underlying equity fund.
  • On average, the investor in the underlying equities (who spent the same dollar amount) had 26% more capital left after 10 years.

    

• Implied Costs and Cash Equivalence [0:07:27]
  • The implied cost of covered call products is substantial.
  • The "break-even fee" (non-tax-deductible fee one would have to pay on underlying equities to match covered call fund's ending wealth) ranged from 1.5% to 2.7% annually, depending on the fund. This illustrates the high cost of the covered call strategy.
  • Another perspective: the equivalent cash allocation (holding cash alongside underlying equities to match covered call fund's ending wealth) ranged from 19% to 36%.
    • This means covered calls are similar to holding a significant portion of cash in your portfolio, but without the downside risk reduction that actual cash provides, as covered calls leave you mostly exposed to downside risk.

      

      

Broader Sample of Canadian Covered Call ETFs [0:10:02]

• To broaden the sample, data for 20 Canadian-listed covered call ETFs were collected and compared against closely matched ETFs of their underlying holdings.
• This analysis focused on total return comparisons due to shorter data series.
• Many covered call funds are niche sector funds or hold concentrated, actively managed underlying portfolios, which adds to their risk for long-term investors.
• Out of 20 funds, only two (both technology covered call funds with short histories and imperfectly matched underlying portfolios) slightly outperformed.
• On average, covered call funds in this sample underperformed comparable underlying equity funds by an annualized 3.25 percentage points. The median underperformance was 2.96 percentage points.

  

Enhanced (Leveraged) Covered Call Funds [0:11:36]

• Enhanced covered call funds not only employ a covered call strategy but also use leverage (e.g., targeting 125% exposure) to increase yield and expected returns.
• While these are fascinating financial technologies, financial innovation often benefits product providers at the expense of investors.
• Across five index funds, enhanced covered call funds generally performed better than regular covered call funds but worse than the underlying equities (during positive return periods).
• They also performed worse during periods of negative returns, as leverage amplifies both upside and downside.
• If an investor is comfortable with higher volatility and leverage, leveraging the underlying equity without writing calls generally makes more sense, as it avoids capping upside returns.
• The leveraged versions of the underlying equities consistently outperformed the underlying, the covered call fund, and the leveraged covered call fund in all five examples.

  

Conflicts of Interest & The True Value of Financial Advice [0:13:33]

• Debunking the Threat to Financial Advisors [0:13:33]
  • The idea that covered call funds are so effective they threaten wealth management firms is false.
  • Wealth management encompasses much more than just creating an income stream. Expert financial advice involves:
    • Goal formation and quantification
    • Asset allocation
    • Cash flow planning
    • Insurance needs analysis
    • Financial product allocation
    • Tax awareness
  • Covered calls might appear to address cash flow planning, but their scope is limited.

    

• Sources of Information & Incentives [0:14:20]
  • Many promotions for covered calls are sponsored by companies selling covered call ETFs, representing a clear conflict of interest. Investors should be aware of these incentives.
  • Ben Felix discloses his own potential conflict: working for a wealth management firm (PWL Capital) that benefits if people delegate portfolio management and financial planning.
  • However, his firm does not use covered call ETFs because they believe these products are detrimental to investors, despite being fiduciaries who could use them if it were in the client's best interest.

Conclusion [0:15:20]

• Beyond potential psychological comfort from income distributions, covered call funds lack redeeming qualities.
• Investors drawn by the promise of "passive income" should thoroughly understand the investment characteristics and the high implied costs detailed.
• Always consider the source of financial information and their underlying incentives.