Covered Call ETFs (or Buy-Write ETFs as they’re known to some) are an intriguing option for investors looking to generate a little extra portfolio income. But you have to have some sense of where the market is heading in order to really profit from them.
Covered Call ETFs are generally known for their high yields. One of the largest covered call ETFs – the PowerShares S&P 500 BuyWrite Portfolio (PBP) – sports a trailing 12 month dividend yield of just over 4%. That number is actually low in the covered call ETF universe as smaller funds like the Recon Capital NASDAQ 100 Covered Call ETF (QYLD) offer yields in the 8-9% range.
Here’s how they work. In a typical equity ETF the fund’s managers buy individual stocks and hold them within the portfolio. In a covered call ETF, managers take the same stock positions but simultaneously write call options on those positions (thus the name “buy-write”). The goal is to benefit from the equity position while at the same time generating an income on the side.
While the yields are nice the overall performance of the buy-write ETF really depends on the direction of the market. In up markets, buy-write ETFs tend to underperform as the written calls start getting exercised limiting an individual stock’s upside potential. Conversely, these funds tend to outperform in sideways or down markets as many of the written calls expire worthless leaving the fund to simply collect the option premiums.
The PowerShares S&P 500 BuyWrite Portfolio has historically performed about as would be expected. It outperformed the S&P 500 during the time right after the financial crisis as stock prices were dropping and subsequently lagged the index for much of the last four years. However, the fund has returned roughly 5% year-to-date outpacing the S&P 500’s return of almost 2%.
If global economic weakness would be expected to continue, covered call ETFs could begin outperforming again.