Covered-Call ETFs Disappoint So Far
Rob Carrick reported that so far cover-call ETF results have been disappointing. Some investors have been surprised by this, but the real surprise is that so many seemed to expect outperformance.
At its core, a covered-call strategy involves owning stocks and selling call options on those stocks. Compared to a strategy of just owning stocks, the difference is obviously the short position in call options. So, for a covered-call strategy to outperform, the excess profits would have to come from the options.
For the options to be profitable, traders would have to consistently trade call options far above their real value. Why would anyone expect this to be the case for such short-term financial instruments?
Even if writing covered calls has no expectation of excess profits, it is reasonable to expect that it will change the volatility of investment returns. But again, I see no reason to expect that we will be left with anything other than the usual relationship between risk and reward: the higher the risk, the greater the expected reward.
Investors who like a covered-call strategy because of the way it changes the volatility characteristics of returns may be making a sensible choice for their situation. But this is very different from expecting outperformance.
Carrick is quite right that “We’ll need a full cycle of stock market ups and downs to properly judge covered call ETFs.” My expectation is that a full stock market cycle will see the covered-call strategy underperform by the costs involved in implementing the strategy. If covered calls prove to be profitable, it would expose a surprising inefficiency in markets.
At its core, a covered-call strategy involves owning stocks and selling call options on those stocks. Compared to a strategy of just owning stocks, the difference is obviously the short position in call options. So, for a covered-call strategy to outperform, the excess profits would have to come from the options.
For the options to be profitable, traders would have to consistently trade call options far above their real value. Why would anyone expect this to be the case for such short-term financial instruments?
Even if writing covered calls has no expectation of excess profits, it is reasonable to expect that it will change the volatility of investment returns. But again, I see no reason to expect that we will be left with anything other than the usual relationship between risk and reward: the higher the risk, the greater the expected reward.
Investors who like a covered-call strategy because of the way it changes the volatility characteristics of returns may be making a sensible choice for their situation. But this is very different from expecting outperformance.
Carrick is quite right that “We’ll need a full cycle of stock market ups and downs to properly judge covered call ETFs.” My expectation is that a full stock market cycle will see the covered-call strategy underperform by the costs involved in implementing the strategy. If covered calls prove to be profitable, it would expose a surprising inefficiency in markets.
A covered call strategy should outperform when the mkt has small gains or down. That's generally the type of mkt when many of these cov call ETF's have existed. But instead they have underperformed
ReplyDeleteMichael,
ReplyDeleteOne hugely important item is missing from this discussion: What strategy is being followed by these covered-call-writing ETFs?
To evaluate the strategy (rather than the performance of the ETFs), it is essential that the ETFs actually write covered calls on 100% of their holdings.
I note that Horizons does that with at least one of their funds. They write ATM and OTM calls. That strategy seeks to earn a significant portion of its profits when the stocks move higher. A more conservative ETF would write ITM options.
BXM (the CBOE buy-write index) also writes OTM options and provides evidence that the strategy slightly outperforms, after dividends. If the ETFs are under-performing, I'd suggest that management fees (0.65%) and trading commissions are to blame.
Here is the unusual part: It is almost impossible, by definition, for a covered call portfolio to earn less than the traditional, uncovered portfolio, when stocks do not rally strongly. Under-performance in a falling market suggests that something is rotten with fund management. business.
I've heard the same criticism against diversification: that it doesn't lead to much outperformance. People need to understand that maximizing returns isn't always the goal!
ReplyDelete@Anonymous and @Mark: It's true that a covered call strategy clips the upside of returns, and we would expect it to work better when stocks are not rising. However, the costs of using the strategy (trading costs and management fees) can certainly consume option premiums.
ReplyDelete@Patrick: I agree that maximizing returns isn't always the goal. But I'd guess that over 90% of covered-call ETF investors bought with the hope of outperformance and little thought about volatility.