Covered Call ETFs: Passive Income or Performance Trap?

Covered Call ETFs: Passive Income or Performance Trap?

Covered call ETFs promise high distribution yields for income-oriented investors, but there is more to it than just high yields. Covered call ETFs have risen in prominence globally. Should you invest in a covered call ETF for its promise of a steady, lower-risk return, or should you stay away?

What is a Covered Call ETF?

A covered call ETF functions in the same manner that a covered call on a single stock works, but structured as a single security. A covered call is when one sells a call option on an asset in which they have a long position, hence having the call “covered” by the long asset. Covered calls can exist on equities, commodities, currencies, or any financial instrument where there is a market.

This will cap the upside of the position to the strike price set by the call option. In return, the seller chooses to sacrifice potential upside and receives a premium on top of any intrinsic value of the option (A call option will have intrinsic value if the call option is in the money, the strike price is below the price of the asset). Covered call ETFs normally sell out-of-the-money calls, which means there is no intrinsic value to the call options when sold.

If the short call option remains in place to maturity and the asset price remains below the strike price, the call will expire worthless, and the overall strategy will return the asset return plus the call option premium. If the asset price exceeds the strike price, the strategy will return the stock price return up to the strike price plus the premium.  If the asset return exceeds the strike price + the premium, just holding the underlying asset would have had a better return, and vice versa.

For example, if an ETF holds a stock priced at $50 and sells a call option with a strike price of $55, it earns a premium. If the stock rises above $55, gains above that level are capped, but the ETF keeps the premium.

Derivative strategies like covered calls can be difficult to implement and maintain for many retail investors. A more simplified form in a structured product like a covered call ETF may be easier and a more viable option.

It should be noted that covered call ETFs can vary in structure dramatically, from the underlying assets as well as the aggressiveness of options sold.

Covered call ETFs are marketed as income producers, with lower risk than the underlying asset.

Digging into the Distributions 

First, the income is not always what it seems. Take ZWC:TSX – BMO Canadian High Dividend Covered Call ETF for example; it offers a forward annualized 6.42% yield, but the unit price has seen little capital appreciation. This is because when calls expire in-the-money, shares/units are called away, then that capital is distributed to unitholders of the ETF, causing a portion of the distribution to be a return of capital.

For 2024, ZWC, paid a total of $1.20 in distributions, but only 55%  ($0.6609) was taxable as dividends, whereas 45% ($0.5391) was a return of capital. Meaning, 45% of that High Dividend yield was your own money. If the yield were only comprised of Eligible Dividends, the yield would be 3.54% – not exactly the highest yield for the risk taken.  Further, as option premiums fluctuate with market conditions, the total income received from selling covered calls is expected to change over time. Higher implied volatility (IV) increased the value of options, so when selling (writing) covered calls you will receive a higher premium, potentially increasing income potential, but lower IV will do the opposite.

It should be noted that if you were to replicate this strategy on your own, the proceeds from covered calls are generally taxed as capital gains, not as eligible dividends.

Should you use a Covered Call ETF for Lower Risk?

When advertising the lower risk, the ETF providers are referring to the volatility (or standard deviation) of returns. This is a standard measure of risk, but it does not tell the whole story. Unlike the misconception, covered calls do not limit downside, only mute it.

Covered call ETFs will reduce overall volatility, this is due to capping the upside volatility, while retaining the downside volatility, less the premium income, creating an asymmetric return profile. When looking at a probability distribution of returns, the covered call distribution shifts to the right as the premium adds to the returns, but also cuts off the right tail once the price exceeds the strike price. Covered Call ETFs can be comprised of multiple securities with differing degrees of strike distance and maturities.

So, how do these funds behave during periods of market stress?

When the markets do poorly, when comparing ETFs with the same underlying, but one selling covered calls and one without, the covered call ETF will perform slightly better, at least during the actual downturn. However, it is not uncommon to have recovery rallies even during prolonged bear markets. If this occurs, the covered call ETF can underperform the standard ETF, depending on the movement of the underlying. If the call options are sold at a lower price as the market declines and then recovers, the covered call ETF can underperform. So, while the low might not be as low, the time to recovery can even be longer.

Comparing a Covered Call ETF to a Standard ETF

We can compare ZWC to the BMO Canadian High Dividend Covered Call ETF ZDV:TSX, while not exact, the underlying holdings are extremely similar and can be used as a comparison benchmark, as it would be a likely non-covered call ETF alternative. As we can see, ZDV has had higher returns for each of the displayed periods. As expected, the non-covered call ETF produces higher returns. Including dividend payments, 55% of days ZDV outperforms ZWC since ZWC’s inception in 2017.

Common Inception since  March 31, 2017

Further, these figures include distribution/dividend reinvestments in the total return. If dividends are not reinvested and used to provide income (like many purchasers of covered call ETFs desire), the return gap will further increase.

Are Covered Call ETFs the Sharpe Choice?

However, what about risk? The covered call ETF does produce a lower standard deviation!

But once you consider the lower returns, you are not seeing a better risk-adjusted return. The sharpe ratio is a common way to assess risk-adjusted returns, where the higher the value, the better.

Comparing Drawdowns

The drawdown of a portfolio can be a risk for investors who may need to access the capital during tough times. Both ETFs share their worst 3-month period, Q1 2020, the COVID crash. ZWC performed relatively better during this period, only falling 23.5% compared to ZDV’s 25.6% decline. However, that slight relative difference was closed by October, and ZDV ended the year with a higher total return. While every stock market decline is different and can take very different paths and lengths to recovery, the COVID crash does exhibit the weakness of covered call ETFs still being exposed to all the downside risk, less the premiums collected.

High Management and Trading Fees Means Less Cash in Your Pocket

Part of the reason why Covered Call ETFs underperform is due to higher fees, both manager expenses as well as trading expenses. Investment managers expect a higher fee when performing more complicated and active tasks, like implementing a covered call strategy. Trading expenses are also higher for covered call strategies, as options generally have a larger bid-ask spread associated with them, and need to be reconstituted when the option expires or is assigned, increasing overall trades and therefore trading costs.

Comparing ZDV and ZWC, the covered call ETF has a significantly higher total expense ratio, as one would expect.

While the difference in the current total expense ratio is only 0.53%, you need to remember that this fee is ongoing, and it reduces the compounding of capital significantly over time.

Do Covered Call ETFs have your Income Covered?

Overall, covered call ETFs are an inefficient asset, with the main draw being towards income-focused investors with a lower risk tolerance. But the risk-adjusted returns are lacking, and only dampen downside volatility, not limit it. Much of the covered calls distribution/dividend yield is purely capital returns, the fund returning your own money, all while collecting higher fees. At certain times when the market expects high volatility or market declines, covered calls have the potential to do the job and offer higher risk-adjusted returns, but over the long term, they underperform due to the inherent structure.

While Covered Call ETFs may appeal to income-focused investors, they often come at the cost of long-term growth. If you’re looking to build real wealth—not just collect yield—explore our exclusive list of high-quality U.S. small-cap stocks poised for growth in 2025.