Covered Call ETFs: Here’s Why New Investors Should Avoid Them

Don’t get fooled by the high yields – covered call ETFs are no free lunch. Don’t think of them as a money printer.

| More on:
Caution, careful

Image source: Getty Images

I cringe at the thought of new investors buying exotic exchange-traded funds (ETFs). Recently, this includes covered call ETFs, which unsuspecting investors are drawn to because of the high advertised yield, sometimes in excess of 5% or more.

Remember, the markets are efficient. That high yield isn’t free money – it either comes from taking on more risk, or in the case of covered call ETFs, selling your future upside gains for a upfront fee, while still being exposed to the downside of owning a stock.

For most investors and under the majority of market conditions, a simple buy-and-hold strategy with a vanilla ETF will handily outperform its covered call cousin on a total return basis. Confused? Keep reading to find out why.

How do covered calls work?

A call option is a derivative contract that gives the buyer of the call the right, but not the obligation, to buy 100 shares of a stock at a specific price called the strike. Think of it as an IOU contract for a stock you can buy or sell as a separate instrument.

On the other side, you have the seller (writer) of the call. If the seller of the call owns 100 shares of the stock they sold a call on, that call is said to be covered. If the price of the stock goes above the strike, the buyer can exercise the call, and the seller will have to sell the 100 shares to them at the strike price.

The seller of the call option collects a upfront fee for doing so, called the premium. The amount of that premium differs but tends to be higher when the expiry date of the option is further out, implied volatility is high, and the strike price is close to the current market price, called “at the money”.

Finally, options contracts lose value daily, accelerating as it nears expiry (theta). The buyer of the call has until a specific day to exercise or sell the call. If the price goes above the strike, the option is “in the money,” and has intrinsic value. If not, the option is “out of the money” and only has extrinsic value.

Why covered call ETFs underperform

The premium received from selling the covered call represents the gains the market thinks is fair to assume you’ll make at the time of expiry, based on the strike you sold at. For all intents and purposes, it’s priced in. All in all, covered call strategies tend to only outperform in sideways markets.

In a bull market, the price will blow past your strike and you’ll be assigned. This means you’ll have to sell your shares to the buyer of the call at the strike price, missing out on larger gains if you simply sold at the share price. This can significantly reduce your return during a large rally.

In a bear market, the call you sold will not get exercised, as the share price will be below the strike price (out of the money). In this case, you can keep the premium you received, but your shares will incur a loss, which may be partially offset by the premium.

However, future calls you sell might not reap as large of a premium, as your cost basis is much higher than the current share price, forcing you to sell at lower strikes. Implied volatility usually also drops, which reduces your premiums even more.

What the numbers say

I plotted a backtest with all distributions invested for two ETFs: BMO Canadian High Dividend Covered Call ETF (TSX:ZWB) and BMO Equal Weights Bank Index ETF (TSX:ZEB). Both hold Canadian Big 6 Banks, but ZWC has a covered call overlay.

There’s no contest here. Even though ZWB has a higher yield of 5.80% versus 3.46%, it underperformed in terms of total return, volatility, best year, and risk-adjusted returns. ZWB had the same downside risk as ZEB, but with its upside capped. This also comes at a much higher management expense ratio of 0.72% versus 0.28%, which eats into your gains over a long time period.

The verdict? Avoid covered call ETFs, unless for some reason you desperately need high monthly income (which may be better met by a combination of preferred shares and corporate bonds anyway).

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Tony Dong has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.

More on Stocks for Beginners

protect, safe, trust
Stocks for Beginners

2 No-Brainer Safe Stocks to Buy Right Now for Less Than $200

You can consider these two safe Canadian stocks for under $200 right now without worrying about near-term market uncertainties.

Read more »

Person slides down a stair handrail
Dividend Stocks

Why I’m Bullish on Cargojet Stock

Cargojet stock has a long and storied history of growth and slumps, but now might be a great time to…

Read more »

grow money, wealth build
Stocks for Beginners

Top Canadian Stocks to Buy Right Now With $2,000

These top Canadian stocks could not only help you make the most of your $2,000 investment but also provide a…

Read more »

rising arrow with flames
Stocks for Beginners

2 Magnificent Canadian Stocks Ready to Surge Into 2025

Improving macroeconomic conditions could help these top Canadian stocks soar in 2025.

Read more »

oil and natural gas
Energy Stocks

The Best Energy Stock to Invest $200 in Right Now

This energy stock isn't going anywhere anytime soon, which is what makes it such a solid investment, especially for dividend…

Read more »

The virtual button with the letters AI in a circle hovering above a keyboard, about to be clicked by a cursor.
Tech Stocks

How to Invest in Canadian AI Stocks for Long-Term Gains

AI stocks don't have to be scary, risky, or any of that. In fact, these stocks are proving to be…

Read more »

space ship model takes off
Stocks for Beginners

3 Stocks That Could Turn $1,000 Into $5,000 by 2030 

Is there a way to grow your money fivefold in five years? Such returns need you to buy the dip…

Read more »

A plant grows from coins.
Stocks for Beginners

2 Growth Stocks Canadian Investors Should Watch in 2025

Long-term growth investors may not want to miss any buying opportunity in these two top Canadian growth stocks in 2025.

Read more »