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Covered-call ETFs: Beware the gap between expectation and reality

Extra-lean bond yields are prompting investors to reach for yield with corporate, high yield and emerging markets bonds. Their appetite for stocks is meagre but investors still hunger for those that regularly spit out cash – sometimes using them as bond replacements. As for investment funds, my keyboard is almost too tired to type out the phrase monthly income fund, but their popularity is similarly driven by low rates.

A newer and more complex breed of income fund stands to disappoint investors yet again, in my opinion. Investors are snapping up exchange-traded funds (ETFs) that use covered call-writing strategies.

The strategy isn't new – covered call writing has been used by portfolio managers for more than two decades – but retail investor interest is growing. Last month alone, covered-call ETFs grabbed a third of the nearly $270-million in net new sales of Canadian-based ETFs. But I suspect that a fundamental misunderstanding of covered call strategies is behind the gap between investor expectations and reality.

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The strategy of selling or "writing" option contracts is espoused by a growing number of investment professionals and non-pros alike. Atop the list of reasons supporting the strategy is the frequently-cited statistic that "90 per cent of options expire worthless" so – the argument goes – why not sell call options and pocket the premium? But I remember seeing this same 90 per cent statistic in my university textbooks (more than a few years ago). I've seen and heard it so often – and the number never changes – that I figured it must be a myth.

The Chicago Board Options Exchange does state that 90 per cent of options go unexercised, but highlights that just 30 per cent to 35 per cent of options expire worthless. While option-writing is often held out as a can't-lose strategy, there are at least three solid fundamental arguments against it.

Covered call writing involves buying stock and selling call options "against" that stock position. When you sell an option, you receive up front the premium paid by the buyer. In doing so, you (as seller) also take on the obligation to sell shares of the underlying stock when and if the call option buyer chooses to exercise his or her options to buy the stock. The buyer will exercise the options if the underlying stock price rises above the call option strike price.

You – the option seller or call writer – pocket the call premium up front. If the price of the underlying stock collapses before the call expires, the call-buyer won't exercise the option because the stock can be purchased more cheaply on the open market compared to the contract strike price. In this case, you continue to own the stock – with all of its downside – but you also keep the premium income.

If the stock soars, the call-buyer will exercise to buy the stock at the (below-market) strike price, forcing you to sell the shares below the market price. So, you get virtually all of the downside risk exposure while cutting off most of the upside potential. And given the history (and expected future) of generally rising long-term prices, this strategy's long-term potential is not attractive.

In other words, this strategy negatively skews the risk-return profile. Covered call writing strategies are promoted as a source of income with less risk than owning stocks outright. But adherents to this approach are giving away too much future upside in exchange for current income. The amount of forgone upside may well dwarf the extra income over time.

Such a strategy can work for years and give the impression that it's the new holy grail. But I expect that the truth will be revealed over time as a series of strong bull periods causes the strategy to fall far behind simply owning the shares outright, without options. That said, because covered call strategies often focus on more volatile stocks – because premium income correlates with volatility – these strategies sometimes suffer more damage during bear markets. Fundamentally, the odds are against this strategy's long-term success.

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Option trading is a quant game and big options traders – which often exclude traditional money managers – are in the best position to find pricing inefficiencies with their sophisticated computer models that can make decisions in a nanosecond. Being on the other side of such trades is not a position I'd want to be in – just another factor tilting the odds against small investors and covered-call ETFs.

Dan Hallett is vice-president and director, asset management, at Highview Financial Group.

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