Covered-Call ETFs are Weapons of Wealth Destruction

Nobody should own a covered-call ETF. They are weapons of wealth destruction.

Nobody should own a covered-call ETF. They are weapons of wealth destruction.

Covered-call (or “buy-write”) ETFs have been around for at least 15 years, although the underlying strategy has been used by institutions and others for a lot longer. The idea is that you buy a group of stocks (such as the S&P 500) and then sell call options against your holdings. By selling those options, you sacrifice some upside, but you gain income from the sale of the options.

Covered-call ETFs have some design differences. They may track a covered-call index (such as the ones managed by S&P and the CBOE) or use the S&P 500 or a subset of it as the equity holdings. They may write options against some or all the holdings. Options can be written at the money or out of the money, and they can be written at various frequencies.

The simplicity of the basic strategy, and the appeal of increasing income and lowering risk explain why option-overlay ETFs have become so popular. Over the last two years, they have accounted for about 12% of the nearly $2 trillion in ETF inflows.

I’ll provide my analysis on a pre-tax and an after-tax basis.

The analysis before taxes

The first problem is that the upside investors sacrificed by selling calls is not offset by the option income.

Their track record exposes this flaw. The table below shows the performance since inception of a group of popular covered-call ETFs that are linked to the S&P 500 (listed alphabetically, data as of 1/7/25):

None of these products came close to matching the performance of the S&P. The ETF with the longest track record (PBP) has trailed the index by 623 basis points. XYLD has the second longest track record, and it has lagged the S&P by 612 basis points.

The sponsors of these products say that they are lowering risk and providing a reliable source of income. But they also claim that they “may be considered as an alternative to existing core equity allocations.” But the above data shows that investors would be much better off owning a low-cost, diversified S&P 500 ETF or index fund (such as VOO) as their core holding.

Don’t be misled by the fact that some of the return from covered-call ETFs is income from option writing, and therefore you are preserving your capital and able to “live off” the distributions. On a pre-tax basis, investors should be indifferent to whether returns come in the form of dividends/income or capital gains. Investors in any of the above funds would be better off in an S&P 500 index funds, selling some of their holdings and dipping into principal as compared to receiving the income from a covered-call ETF.

Risk-adjusted returns

It’s true that covered-call ETFs lower risk as measured by standard deviation. The standard deviation for PBP (the ETF with the longest track record) is 9.89 versus 17.4 for VOO. But if your goal is to lower your risk, this is not an efficient way to do it. You are sacrificing too much in return. A 60/40 portfolio would be a much better choice. The global 60/40 has returned approximately 6.8% (versus 4.67% for PBP), with a standard deviation of 9.6 (versus 9.89 for PBP). (A U.S.-based 60/40 would have done better.)

But a better measure of risk is the chance of having less wealth over your investment time horizon. On this basis, the covered-call strategy is guaranteed to perform worse than VOO, unless you have a very unusual scenario of a prolonged bear market.

Explaining the underperformance

There are many reasons why covered-call ETFs underperformed an index fund. The most obvious is their high cost. Even the cheapest ETF, with a 0.29 expense ratio, is 26 basis points more expensive than VOO. The stock market has historically returned approximately 9% annually. This upward trend works against a covered-call strategy. If the ETF sells at-the-money options, it will forego all upside on the underlying index. Nobody should be surprised that selling calls against an asset that has increased 9% annually will generate losses.

The amount of income from selling an option does not depend on the price of the underlying index; it is dependent on several factors, most importantly the volatility of the index and the risk-free rate. To some extent, covered-call investors are betting on volatility. But the more volatile the underlying asset, the more they lose on the upside.

These ETFs use active management. The overwhelming evidence from academic research is that active management will underperform a passive, low-cost index.

Lastly, some of these ETFs do option trading based on a fixed schedule, exposing them to “front running” by traders.

There have been times when covered-call ETFs outperformed an index. The table below shows the performance of the above ETFs relative to VOO over the prior three years:

All underperformed in the up years of 2023 and 2024, and all outperformed in 2022, when both stocks and bonds performed poorly. But the outperformance in 2022 was more than offset by the underperformance in 2023 and 2024, as shown by the fact that all ETFs have trailed the S&P 500 since their inception.

One might argue that a covered-call strategy is likely to outperform the S&P during a multi-year bear market. That is possible, but I doubt it is the most cost-effective strategy to protect against downside losses. As Alan Roth showed in an article about buffer ETFs (another option-overlay strategy), a combination of an equity index fund and a bond index fund (or T-Bills) provides reliable diversification against equity holdings.

After-tax analysis

ETFs are more tax efficient than mutual funds and are generally preferable for non-tax-sheltered accounts.

But when taxes are considered, the problem with covered-call ETFs is that selling options against equity holdings turns capital gains into ordinary income. That is highly undesirable.

But it is not that simple.

Some of ETFs listed above use section 1256 strategies. This allows 60% of the gains or losses on option contracts to be treated as short- or long-term capital gains or losses. This preferable tax treatment is contingent on whether there are gains or losses on the equity holdings and on the options. But the net result is that many of these ETFs end up making distributions as a return of capital, rather than as income. While this reduces the tax burden on the distribution, it lowers the basis on your investment.

That creates a bigger tax burden when the ETF is sold (as compared to an index ETF such as VOO).

Weapons of wealth destruction

A recent Wall Street Journal article (Your Fancy, New ETF Might Be a Little Too Fancy) lamented the fact that 30% of the ETF launches in 2024 were what it deemed “complex” strategies. Those high-cost product inventions have enriched the bankers that created them but provided little value to investors.

Covered-call option ETFs are one of those value-destructive products. I analyzed only those ETFs linked to the S&P 500, but I expect that my conclusions would apply to products tracking other indices, such as the Nasdaq. There are also ETFs that write covered calls on single stocks, but I put those in the category of speculation rather than investments.

It is incredibly difficult to create investment products that are better for investors than a low-cost, diversified index fund or ETF, and this is another example that underscores this maxim.

Let me know what you think in the comments section.

Robert Huebscher was the founder of Advisor Perspectives and its CEO until the company was acquired by VettaFi in 2022. He was a vice chairman of VettaFi/TMX until April 2024.