I’ve Never Been More Bullish On Covered Call ETFs Than Now (But With One Caveat)

Introduction

I have been advocating covered call ETFs for quite some time. Since for high- and durable income investors, the investable universe is relatively small, each instrument or asset class that comes with a prudent 10%+ yielding offering simply must be at least considered for portfolio inclusion.

This is especially the case now, when the scarcity of attractive (and safe) income producers has become more pronounced as the Fed has already made several base rate cuts. Because in finance most valuations are derived from discounted cash flow models, which in turn are based on risk-free rates, there is a natural tendency for asset prices (valuation) to appreciate when the denominator (discount rate) goes down. The higher the valuations, the lower the yields. So, in this context, covered call ETFs – oftentimes yielding well above 10% – come into play nicely.

The covered call ETF promise

Apart from the enticing yield part, covered call ETF products fit very well in environments, when there is increased volatility and/or uncertainty in the system.

Why so?

Well, what covered call ETFs do is they go long a specific index or basket of securities, which at the start makes the investment profile of payoff identical to any type of direct holding. The downside is bound by 0, and the upside is theoretically unlimited.

However, these ETFs do not stop here; they take an additional step, which is selling call options against the underlying holdings. This process changes the payoff profile to the following:

• Enhanced downside protection (in the amount of option premiums).
• Enhanced current income from collected option premiums.
• Capped upside potential (bound by the written call option strike values).

In a nutshell, the best environment for covered call ETFs is when there is a heightened volatility (higher vol makes options more expensive and thus allows for capturing juicier premiums) that is not caused by rallying markets, which would introduce a huge opportunity cost for investors.

The picture below summarizes the relationship between covered call ETF performance and various market dynamics:

 

So, the question is whether we really believe that there is a strong bull market ahead of us that would materialize in the foreseeable future. And here I am talking about rallying market conditions, which would trigger the manifestation of opportunity cost for covered call ETF investors.

Given the combination of historically expensive valuations, 3 years of a robust bull market behind us, more back-end loaded interest rate cuts, increased geopolitical tensions/uncertainty, and already visible signs of investor skepticism about the justification of sky-high valuations for the biggest market sector (i.e., AI), I would not assume a strong bull market as my base case scenario.

Instead, I see a clear case for high volatility, where the expensive valuations help exacerbate the market’s reaction to each incoming data point that is either negative or positive but below the market’s expectations.

So far this year, the VIX – a measure of implied vol on the S&P 500 (SPY) – has moved in line with such a case:

 

Unsurprisingly, this coincides with the struggling market – SPY and the Nasdaq-100 (QQQ) – and especially certain pockets of the AI-world such as Nvidia (NVDA), Microsoft Corporation (MSFT) and Palantir (PLTR) that have experienced some really sharp corrections:

 

Once again, the overall backdrop is very favorable for being long volatility, and the biggest risk that is associated with covered call ETFs – experiencing an opportunity cost – seems to be quite distant.

However, there is an important caveat to this assumption or conviction that covered call ETFs can lead to outperformance and even more enticing distributions due to rising volatility.

The caveat (my strategy)

My closest followers will likely confirm this, but I have articulated several times before the inherent value of considering relatively new and non-AI-linked covered call ETFs for portfolio inclusion.

So far this year, that thesis has been playing out very well, and now we have really solid data to prove it.

Let me give a quick backdrop.

The overall covered call ETF space has been on a strong ride in the past couple of years. Quite a lot of capital has flown into this area, especially from retail investors (including myself), who seek portfolio income enhancement and diversification.

However, the issue is that the largest and most popular covered call ETFs are all linked to either SPY or QQQ, which of course introduces a significant bias towards the overvalued AI and thus growth factor. Just take a look at the largest covered call ETF list below:

• JPMorgan Equity Premium Income ETF (JEPI): ~$43 billion of AuM.
• Nasdaq Equity Premium Income ETF (JEPQ): ~$34 billion of AuM.
• NEOS Nasdaq-100 High Income ETF (QQQI): ~$8.2 billion of AuM.
• Neos S&P 500 High Income ETF (SPYI): ~$7.5 billion of AuM.

The concentration into SPY and/or QQQ is undeniable.

Moreover, many newer products that have been launched for trading are also exposed to the same AI/growth factor. For example, YieldMax has created even AI ticker-specific funds like the YieldMax NVDA Option Income Strategy ETF (NVDY) and the YieldMax TSLA Option Income Strategy ETF (Original Post>

We have several zero-day-expiry covered call vehicles, which are literally all tied to either SPY or QQQ – e.g., the Roundhill Innov-100 0DTE Covered Call Strategy ETF (QDTE) being one of the largest ones.

Now, all of this has two problems:

1. Investors, who have not done their due diligence and just poured capital into the largest and most well-known covered call ETFs have likely assumed an elevated concentration risk.
2. Being exposed to the AI and/or tech growth factor is probably not the safest situation to be in right now (see the arguments outlined above).

I am not saying that AI-linked covered call ETFs such as QQQI or the Rex Fang & Innovation Equity Premium Income ETF (FEPI) do not have a place in income-oriented investor portfolios. In fact, these types of products are really welcomed as they provide me with an opportunity to access the AI world without sacrificing the yield component that is so vital for me as an income investor.

Yet, my argument is that exposure to such covered call ETFs should be kept balanced and, seeing the prevailing market situation, preferably, even underweight in the context of the overall covered call ETF portfolio bucket.

Instead, I see huge merit in tilting the covered call ETF bucket towards high-yielding out-of-the-money covered call ETFs (no ATM call funds, to avoid too excessive risk of an opportunity cost) that are based on more durable and defensive underlying indices that can better shield the downside that seems to be quite relevant for AI-linked names.

The chart and the table below encapsulate how there is indeed a value in deploying yield-chasing capital in less popular (non-AI based) covered call ETFs:

 

And here is a summary of my covered call ETF recommendation list to implement the tactic play in practice:

* The yields are annualized based on the most recent monthly dividend payment.

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