Risk is the bane of investing and it’s the primary issue advisors and investors look to avoid or, at the very least, mitigate. Myriad strategies, many in exchange traded funds form, purport to accomplish that objective, but many demand sacrifices, including reduced income.
Covered call or buy-write ETFs don’t require that sacrifice and that’s likely one reason why these funds have soared in popularity in recent years. By some estimates, the universe of covered call ETFs experienced population growth of 500% over just the past two years.
Add to that, advisors and income investors are flocking to the funds this year as highlighted by more than $17 billion in year-to-date inflows as of July 31. In addition to yields that often exceed those (by wide margins) found on equity and high-yield bond funds, covered call ETFs, generally speaking, draw a crowd because they’re easy to understand.
Essentially, a buy-write ETF tracks an index of stocks or holds equities and proceeds to write covered call options on those stocks. In turn, the investor’s downside risk is mitigated while the income profile is enhanced.
Buy-Write ETFs Differences Matter
With population of buy-write ETFs expanding, it’s essential that investors understand that simply because fund titles sound similar, that doesn’t imply “twins” traits.
“We believe another important consideration is how different ETFs manage their call-writing strategies. Some funds seek to maximize distributions by selling (i.e. writing) calls against a high proportion of their underlying equity holdings,” according to First Trust. “Such strategies effectively forgo potential appreciation of those holdings in exchange for the income generated from call premiums. Other call-writing ETFs may sell calls against a smaller proportion of their underlying holdings, forgoing some level of call premiums in favor of more potential upside participation.”
First Trust’s commentary on the matter is credible because the Illinois-based fund sponsor is the issuer of multiple buy-write ETFs –two which are close to a decade old.
The issuer adds another important point for investors considering buy-write ETFs for income. Depending upon a fund’s methodology, it’s distributions can vary because options premiums do the same, but there are ways to for ETFs in this category to steady those variations.
“Options premiums tend to rise and fall with equity market volatility, so a strategy that seeks to maintain a relatively constant overwrite percentage may produce larger distributions as volatility increases and smaller distributions as volatility decreases. On the other hand, a strategy seeking to distribute a more stable level of income may be able to achieve this objective by selling fewer calls (i.e. with more upside potential) as volatility increases and more calls (i.e. with less upside potential) as volatility decreases,” concludes the issuer.
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