By Philip van Doorn
A group of ETFs and mutual funds using options strategies in the stock market features dividend yields as high as 11.5%.
There are inflation worries as the U.S. economy recovers from its pandemic doldrums, but interest rates are still very low. This means many investors are forced to go to the stock market to generate income.
One way funds can generate extra income is by using option strategies. And some of those have led to returns that can appeal to growth investors.
Those strategies are used by covered-call ETFs, mutual funds and closed-end funds. Funds with high yields and the highest 10-year returns are listed below.
Covered-call strategies are the “predominant” options strategies used by mutual funds, according to Edward Szado, chair of the Department of Finance and an associate professor at Providence College in Rhode Island. Szabo and Keith Black, managing director of content strategy at the Chartered Alternative Investment Analyst Association (CAIA), published a study, “Performance Analysis of Options-Based Equity Mutual Funds, CEFs, and ETFs,” which listed the largest and oldest funds making use of options strategies. You can download the study, updated through 2017, here (link).
During an interview, Szado said his research focused on funds for which options trading is a “fundamental” part of the strategy, rather than something done occasionally. He also said there has been “significant growth among pension funds and endowments” in the use of options strategies.
According to Cboe Head of Index Insights Matt Moran, “the overall options industry had record volume last year, up 50% from a year earlier.”
“Many investors are buying individual call options,” he said.
A call option is a contract that allows an investor to buy a security at a specific price within a certain time period, while a put option allows an investor to sell at a specific price until the option expires.
A covered-call option is one that you can sell when you already own the shares. For example, if you own shares of a company that you purchased at price of $100, you might decide that you would be willing to part with the shares at a price of $110. You can sell an option to another investor, allowing them to buy your shares for $110 (the strike price) by a certain date. You receive a fee for selling the option. If the stock doesn’t rise above $110 by the time the option expires, you keep the fee and are free to write another option and generate more income. The more volatile the stock market, the more fee income is potentially available.
So a covered-call strategy enhances income. It can provide downside protection because you keep the income if your stock goes down in value, and can then write another covered-call option. But the risk is missing out on upside. Getting back to our $100 stock above, if you sell a covered-call option with a strike price of $110, and your stock doubles the next day, you get your $10 gain and your fee for writing the option, but lose out on $90 of upside.
A covered-call strategy may make for too much busy work for an individual investor or investment adviser. So there are plenty of exchange traded funds and mutual funds available that make use of those strategies.
As their names make clear, exchange traded funds are publicly traded on stock exchanges. You can buy or sell at any time when an exchange is open.
An open-ended mutual fund is priced only once a day, when the stock market closes. You can only buy or sell shares at that time. A mutual fund’s share price is actually its net asset value (NAV), which is simply the valuation of all its assets divided by the number of shares.
So an ETF or closed-end fund has a share price and an NAV. Those prices are usually very close, but it is possible for an ETF to trade at a significant premium or discount to the NAV.
Click here (link) for a more detailed discussion of how covered-call options work, including specific examples, and descriptions of two ETFs employing the strategies in different ways: The Amplify CWP Enhanced Dividend Income ETF (DIVO) and the Global X Nasdaq-100 Covered Call ETF (QYLD).
The research by Szado and Black focused on funds that had been around for at least 10 years, through 2017. Some of the mutual funds they researched are listed below.
This first list includes the the largest ETFs employing options strategies, most of which are relatively new. The list excludes ETFs that are leveraged and those that are focused on specific commodities, such as silver or gold.
Here are nine ETFs employing options strategies with distribution yields of at least 3%, sorted by assets under management (AUM):
The yields are actually distribution yields, not dividend yields, because some of the income comes from option premiums, which are considered short-term capital gains. Some of what is distributed to shareholders may also be a return of capital, which is explained below. These ETFs all feature monthly distributions, except for the FT Cboe Vest S&P 500 Dividend Aristocrats Target Income ETF (KNG), which pays quarterly.
DIVO and QYLD provide an interesting contrast of styles.
Kevin Simpson, who manages the DIVO portfolio, typically only writes covered-all options on a handful of the 25 to 30 blue-chip stocks that he holds. His main objective is long-term capital growth, with enhanced income from writing some covered calls. The ETF aims for a distribution yield of at least 5%. Its total return of 9% for 2021 through April 21 compares to a return of 12% for the SPDR S&P 500 ETF Trust (SPY). Simpson said his focus on quality large-cap companies leads to “a lower risk profile,” also with lower covered-call premiums than some other options-based strategies, most of which are passive.
QYLD follows a strategy of holding the stocks that make up the Nasdaq-100 Index , and writing covered-call options against the entire index. This has led to consistent distribution yields above 11%. But its performance also shows what an investor gives up by focusing on the high level of monthly income. Over the past year, the Invesco QQQ Trust (QQQ), which tracks the Nasdaq-100, has returned 67%, while QYLD has returned 32%.
Looking further at the Global X group of ETFs on the list, the Global X S&P 500 Covered Call ETF (XYLD) and the Global X Russell 2000 Covered Call ETF (RYLD) follow the same strategy as QYLD, with their respective indexes. But the Global X Nasdaq 100 Covered Call & Growth ETF (QYLG) and the Global XS&P 500 Covered Call & Growth ETF (XYLG) only write covered calls against 50% of their indexes, for growth and income strategies.
QYLG and XYLG were established in September and are still very small. Global X VP and research analyst Rohan Reddy said “ETF investors don’t usually rush in right away.” He expects a rapid inflow of money once the ETFs once they had 12-month track records.
Each ETF on the list has a different strategy. You should read as much as you can about any of them before considering an investment. You also need to tie any investment with your income or growth objectives.
Getting back to the research by Szado and Black, there are scores of mutual funds employing options strategies with much longer track records than most of the ETFs above.
Here are the 10 funds (mostly closed-end funds) listed in the research with current distribution yields of at least 3% (actually all are above 5%) with the best 10-year total returns through April 21:
At Morningstar, five stars is the highest rating.
Return of capital and tax implications
For U.S. investors, most dividends paid by publicly traded companies to common stockholders are “qualified dividends,” which means they are taxed at lower rates. Ordinary dividends are taxed as regular income, which means they are taxed at higher rates for most investors than qualified dividends.
Income from option premiums is categorized as short-term capital gains, which are also taxed as ordinary income.
So if you are focused on keeping as much of your investment income as possible in the “qualified” category, you need to consider the tax implications carefully. A higher yield may justify the higher tax rate. As you do your own research, you can look back at each ETF or mutual fund’s distributions to see the breakdown between qualified dividends, short-term or long-term capital gains and return of capital.
A return of capital is when a fund returns some of your own principal to you as part of the distribution. This money isn’t taxed because it was yours to begin with. Returns of capital can confuse investors and even be controversial. The capital that is returned comes out of the NAV.
Why would a fund send your own money back to you? One reason might be that its option income has been relatively low when the stock market is performing well, as it did during the second half of 2020. DIVO had a considerable return of capital last year, and Amplify ETFs CEO Christian Magoon said this is because the fund is designed to maintain a distribution yield above 5%, even if a return of capital is necessary.
“There are two types of return of capital: accretive and destructive,” he said. Accretive means if the NAV is continuing to increase, despite a return of capital, the fund is meeting its objective of capital growth while continuing to provide the income. A destructive return of capital would mean the NAV declines over the long term while capital is being returned.
So in a “bullish market,” DIVO will write fewer covered calls, but also enjoy more upside from not being forced to sell stocks. That will mean a return of capital is more likely.
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