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investor clinic

What do you think of covered call funds? The yields look very enticing.

Focusing on the yield alone is a big mistake with any investment. Covered call exchange-traded funds (ETFs) – which typically have yields in the mid to high single digits – come with risks that many investors don't appreciate.

Before I delve into those risks, I'll explain how covered call ETFs work.

To generate extra income, these ETFs sell covered call options on their underlying stocks. The funds distribute the income to investors, which is how they can pay such lofty yields. But there's no such thing as a free lunch in investing, and these products are no different.

Let's look at a simple example. Say you buy a share of XYZ for $50. You then decide to sell a covered call option on your share for $3. We'll assume the option gives the buyer the right to purchase your XYZ share, before a specified date, at $52. It's called a "covered" option because you own the share.

You pocket the $3 option premium, which sounds like a sweet deal. As long as the price of XYZ doesn't rise above the $52 "strike price," the option buyer won't exercise it because he can buy the share for less on the open market. You'll get to hang on to your XYZ share, and the option will eventually expire. You win.

But what happens if the price of XYZ rises to, say, $57? The option holder would then "call" the share from you for $52, because the strike price is lower than the stock's current market price. Clearly, in this case you would have been better off not writing the option at all, because you would have had a capital gain of $7 instead of pocketing just a $3 premium and a $2 gain. So the option buyer would win.

This illustrates one of the main drawbacks of covered calls – they limit the fund's upside potential. You get a small amount of extra cash now in exchange for giving up potentially larger gains later. Since the stock market generally rises over time, this is a dangerous tradeoff.

Fans of covered calls claim that the funds provide downside protection, but that's only true to an extent. In the example above, if XYZ fell to $47 from $50, you would break even because of the $3 option premium that you collected. Below $47, however, you would have no protection at all.

What's more, if stocks are falling, covered call funds have to write options at progressively lower strike prices if they want to keep generating premium income. If the market then rebounds, the fund's gains would be limited because option buyers would exercise their calls.

Another thing to keep in mind is that, with covered call funds, distributions aren't fixed. Option premiums fluctuate depending on market volatility, which in turn can affect the fund's income. This makes covered call funds unsuitable for investors who rely on a steady income stream.

I had a quick look at several covered-call ETFs, and in many cases their distributions have been falling – in some cases sharply. The funds' total returns – from share price changes and distributions – have also been disappointing.

"Covered call strategies have seen challenges in 2012," said a report published in February by National Bank Financial. A "majority of the ETFs lagged their plain vanilla equity benchmarks."

Of the 15 covered call funds that National Bank examined, only two – both in the materials sector – performed better than their comparable indexes in 2012. In several cases, covered call ETFs had less than half the gains of the relevant benchmarks, which do not employ a covered call strategy.

Bottom line: Don't be seduced by the juicy yields of covered call funds. You may well do better by investing in a regular ETF.