Why Covered Call Strategies are Detrimental for Long-Term Investors: Lower Returns, Capped Upside, and Increased Risk

Summary:

This video argues that covered call strategies are financially detrimental for long-term investors, despite being marketed for their high distribution yields.

Misleading Income: Distribution yields from covered calls are not true income but premiums with associated liabilities that often lead to lower total returns.
Asymmetric Risk Profile: Covered calls cap upside potential while leaving significant downside unprotected, eliminating the beneficial mean-reverting behavior of stocks.

Illustration of a covered call's asymmetric risk profile, showing capped upside and unprotected downside [ 00:00:20 ]
Reduced Expected Returns: Higher distribution yields in covered call strategies mechanically correlate with lower expected total returns due to reduced exposure to the underlying asset.
Real-World Underperformance: Analysis of several covered call ETFs (e.g., BMO, Global X, Hamilton, JPY, TSLY) demonstrates consistent underperformance compared to their underlying equities over various rolling periods.
Higher Costs: These funds typically incur higher management and trading expense ratios, further eroding returns.
Dangerous for Capital: Relying on these high yields for spending can quickly deplete capital, making them unsuitable for long-term financial planning.

The Misconception of Covered Call Income [0:00:00]

The video begins by asserting that the idea of covered calls generating income is misleading. These strategies are fundamentally expected to underperform their underlying equity, with underperformance increasing as higher distributions are targeted. For long-term investors, covered calls amplify risk by leaving the downside exposed while limiting upside potential, thereby removing the mean-reverting characteristic of stocks, which is vital for long-term returns.

Illustration of a covered call's asymmetric risk profile, showing capped upside and unprotected downside [ 00:00:20 ]

Income Preference Bias: [0:00:38] Investors often have a strong behavioral bias towards seeking income, leading them to pursue funds with high distribution yields.
- Fund managers capitalize on this by marketing high distribution yields to attract investors.
- However, these advertised yields for covered calls are not indicative of expected total returns; they are often inversely related.
  - Higher yields mechanically lead to lower expected total returns.
  - Total returns are what ultimately fund expenses like groceries, not just distribution yields.
Video's Core Arguments: [0:01:27] The video aims to explain:
1. Why distribution yields are not actual returns.
2. How covered calls inherently reduce expected returns.
3. Why the return profile of covered calls makes them particularly risky for long-term investors.
4. Real-world performance of covered call funds will be used to demonstrate these points.

Mechanics of Covered Calls and Their Impact on Returns [0:01:48]

A covered call strategy involves owning an equity and selling a call option on that equity. The premium received from selling the call option is often distributed as cash, leading to high distribution yields.

Selling a Call Option: [0:02:03]
- Definition: Selling the right to buy the underlying stock at a predetermined "strike price" in exchange for a premium.
- Consequence: If the stock price rises above the strike price, the option holder will exercise, forcing the fund to sell the stock below its market value, thus capping upside returns.
Reduction in Equity Exposure (Short Delta): [0:02:50]
- Call options have positive exposure (delta) to their underlying equity. Selling a covered call reduces this exposure, effectively "shorting" the underlying equity.
- Higher Yields, Lower Exposure: To generate higher income, funds sell options with lower strike prices, which results in higher "short delta" and, critically, lower expected total returns.
- Asymmetric Risk Profile: [0:04:33] The reduction in exposure is asymmetric; investors retain most of the downside risk while capping potential upside gains at the strike price.
  - Missing out on market recoveries after downturns can be very costly.
The Volatility Risk Premium (VRP): [0:05:00]
- Potential Benefit: Equity options are often priced with an implied volatility higher than realized volatility, creating a "volatility risk premium" for option sellers.
- Insufficient Offset: Since around 2011, this premium has generally not been large enough to offset the reduction in equity exposure, leading to poor performance for covered call strategies.
- Market Crowding: The proliferation of retail funds chasing these strategies may have contributed to the VRP becoming insufficient.

Covered Calls and Long-Term Investing [0:05:41]

For long-term equity investors, stocks typically benefit from mean reversion (i.e., poor performance tends to be followed by better-than-average performance). Covered calls eliminate this crucial feature.

Comparison of bond vs. stock performance, highlighting stocks' mean-reverting tendency [ 00:05:58 ]

Eliminating Mean Reversion: [0:06:26]
- Selling calls lowers expected returns and removes the mean-reverting tendency of stocks by capping upside returns.
- It only marginally improves the downside by the option premium amount, meaning investors get most of the downside with limited upside.
Unsustainable "Passive Income": [0:06:50]
- Distribution yields from covered calls are not sustainable long-term income like bond interest.
- The option premiums come with a liability that lowers expected returns and transforms the shape of the distribution of returns into something much less favorable for long-term investors.
- Marketing these products as "passive income" is irresponsible, especially when it encourages risky behavior like borrowing to invest based on high distribution yields.
- Spending these distributions can quickly deplete capital.

Real-World Performance of Covered Call ETFs [0:08:44]

Empirical data from live covered call ETFs consistently shows underperformance relative to their underlying equities.

BMO Covered Call Utilities ETF (ZUT): [0:09:05]
- Launched: October 20, 2011.
- Distribution Yield: 7.37% (vs. 3.43% for underlying equities).
- Performance: Trailed the underlying by an annualized 2.6 percentage points since inception.
- Outperformed in less than 30% of three-year rolling periods, and less than 15% in four-year rolling periods.
- Comparison: A 60% equity/40% cash portfolio tracked ZUT closely but with less downside and uncapped upside.
  - Morningstar Research shows similar results across 22 single-stock covered call ETFs, where a cash/stock combination often outperformed with lower volatility and higher Sharpe ratios.
BMO Covered Call Canadian Banks Fund (ZWB): [0:10:43]
- Launched: January 28, 2011.
- Distribution Yield: 6.13% (vs. 3.61% for underlying equities).
- Performance: Underperformed by an annualized 2.71 percentage points since inception.
- Outperformed in less than 1% of three-year rolling periods.
Global X S&P/TSX 60 Covered Call ETF (HXCC): [0:11:06]
- Launched: March 16, 2011.
- Distribution Yield: 7.67%.
- Performance: Trailed the iShares S&P/TSX 60 ETF by 3.65 percentage points since inception.
- Trailed in 92% of three-year rolling periods.
High-Yield Maximizer ETFs: [0:11:40]
- Strategy: These funds target even higher yields (e.g., >10%) by selling "at-the-money" call options, which exacerbates all the aforementioned issues.
- Hamilton U.S. Equity Yield Maximizer ETF (SMAX): [0:12:12]
  - Target Yield: 12%.
  - Performance: Underperformed an S&P 500 ETF by an annualized 4.48 percentage points over its short history.
- JPMorgan Equity Premium Income ETF (JEPY): [0:12:26]
  - Gained popularity in 2022 by outperforming the S&P 500, with a prominently marketed high distribution yield.
  - Performance: Underperformed an S&P 500 ETF by 5.92 percentage points since its May 2020 inception.
Single Stock Covered Call ETFs (e.g., TSLY): [0:13:17]
- Concept: Covered calls on individual stocks, often with astronomical distribution yields.
- TSLY (on Tesla shares): [0:13:34]
  - Distribution Rate: 48.59%.
  - Performance: Underperformed Tesla by over 20 percentage points annualized since its November 2022 inception.
- These extreme examples clearly show the inverse relationship between high derivative income yields and low expected returns.

Higher Fees and Conclusion [0:13:57]

Covered call funds also come with significantly higher fees and transaction costs.

Cost Comparison: [0:13:57]
- Average Management Expense Ratio (MER) for covered call funds (excluding single stock funds): 0.63%.
- Average Trading Expense Ratio (TER): 0.16%.
- Funds holding the same underlying equities: average MER of 0.25% and average TER of 0%.
- Investors pay a substantial premium for covered calls, primarily to access their psychological "income" benefit despite the financial downsides.
Final Assessment: [0:15:19]
- Covered calls offer no special advantage; they are akin to holding equity with a significant cash component, but with capped upside and unprotected downside.
- They are likely detrimental to most investors' expected outcomes.
- The high yields come at the cost of lower expected and realized total returns.
- The volatility risk premium has not been sufficient to offset these reductions since 2011.
- The long-term performance of live covered call strategies, measured by total returns, clearly demonstrates these downsides.