Do You Need a Covered Call ETF?

Mounting fiscal problems in Europe finally spilled over into global markets last week, sending shares plunging sharply lower. At one point on Thursday, the Dow was down close to 1,000 points, with several stocks and ETFs rendered nearly worthless by a still-unexplained “flash crash” began.

Then on Monday, investors awoke to news that the eurozone was authorizing a trillion dollar bailout plan to help stop the contagion from spreading to other weaker markets like Spain and Portugal, giving markets a big boost. With the chaos of late 2008 still fresh in their minds, some investors have tweaked their portfolios in light of recent developments, seeking out safe havens such as gold and Treasuries or sliding into less volatile equities.

Other investors are taking a renewed interest in a strategy abandoned during the recent recovery; the covered call. A covered call consists of going long on an underlying security while selling call options on the same underlying security. This has the effect of generating additional income (the premiums received from selling options), which helps to offset some losses when markets are falling.

When markets are rising, however, the call options sold can come “in-the-money,” offsetting gains generated by the long position in the underlying security. This lower-risk, lower-reward strategy can be difficult to implement in traditional accounts; investors usually must apply for approval to trade options and some brokerage firms do not even offer the service. But there are multiple ETF options for investors looking to gain exposure to a covered call strategy.

There are two indexes that are currently linked to covered call ETFs: the S&P 500 and the Nasdaq. ETFs employing the covered call strategy have lagged behind traditional beta funds over the last year as markets headed higher, but have sharply outperformed the broad market during the recent period volatility and declining equity prices.

Last week, the SPDR S&P 500 ETF (SPY) was down about 6.4%, while the PowerShares S&P 500 BuyWrite Portfolio (PBP) lost only 5.8%. It was the same story for the PowerShares QQQ Trust (QQQQ) and Nasdaq-100 BuyWrite Portfolio (PQBW); the covered call ETF posted a big loss on the week, but was well ahead of the QQQQ.

It is important to remember that while covered call funds tend to outperform when the market is declining, they often underperform when prices are soaring. Over the past 52 weeks QQQQ has significantly outperformed PQBW while SPY has outgained PBP by a wide margin.

There’s one more factor that’s worth considering when looking into covered call ETFs; they often pay a robust dividend yield related to both the underlying long positions and the premium they receive from writing call options. In the case of PBP, this works out to a yield that is more than twice as high as SPY; 4.5% compared to 1.9%. PQBW pays out a dividend yield of almost 5%, compared to just 0.6% for QQQQ.

These figures suggest that the covered call strategy may be more appropriate for investors who are seeking to reduce their volatility and increase their current income levels while the pure play options may be better for those with a longer time horizon that are better able to weather the recent market volatility.

Disclosure: No positions