This type of ETF offers portfolio income along with some complexity. How to determine if it’s right for you

Published Thu, Feb 15 20241:58 PM EST

Covered call exchange traded funds offer investors an attractive combination of equity exposure and income, but you'll want to do some research before snagging one of these ETFs — especially as stocks roar in 2024. These so-called derivative income funds — which include popular covered-call offerings such as the JPMorgan Equity Premium Income ETF (JEPI) — gathered $22 billion in flows last year , according to Morningstar. These strategies invest in equities but also use derivatives, including selling call options, to generate additional income and help offset losses in tough times. "It's not for someone who is deciding 'Do I buy the S & P 500 or this covered-call writing product?'" said Rob Schultz, a certified financial planner and senior partner at NWF Advisory in Encino, California. "It's more 'Do I buy a balanced fund or dividend-paying stocks?' We also look at people's ability to stay in their seat during market volatility," he added. A trade-off for less volatility These funds aim to provide less volatility in tumultuous markets. Consider that JEPI posted a negative return of 3.52% during 2022, compared to the return of -18.11% on the S & P 500, showing the buffering benefits of the additional income generated from call writing. However, when the S & P 500 posted a total return of 26.3% in 2023 as tech stocks pulled the major averages higher, JEPI gained a more modest 9.81%. Even as stocks' runaway rally continues into early 2024, there's a case for these funds, some say. "I don't see volatility drying up, especially with where inflation is and this being an election year," said Barry Martin, portfolio manager of the Shelton Equity Income Fund (EQTIX) . "We believe the market is going to stay choppy for the foreseeable future." EQTIX also uses a covered-call strategy, and Martin sees it gaining favor in an environment where returns are modest. "Do we expect the market to appreciate another 30% after last year?" he said. "Most forecasts are calling for 5% to 10%, and that makes more sense than anything." Within a client's portfolio, covered call ETFs might be ideal for retirees who are seeking equity exposure and some measure of downside protection. Held within an individual retirement account, a covered call ETF could produce sufficient income to allow retirees to easily meet required minimum distributions without drawing down too much on principal, Schultz said. As of 2023, account owners must start taking these mandatory withdrawals from retirement accounts at age 73. Some advisors look outside of the ETF world to generate income from options. Ashton Lawrence, CFP and senior wealth advisor at Mariner Wealth Advisors in Greenville, South Carolina, has used cash-secured puts for clients who missed the runup in stocks and have excess cash on the sidelines. A put option gives an investor the right to sell a stock at a stated or strike price before an expiration date. With cash-secured puts, you write a put option and hold sufficient cash to buy the stock in the event the put is assigned. Investors writing the put option make money from the premiums received. There are risks: The potential profit is limited to the premium received, and if the stock dips and then soars above the strike price, you can miss out on the upside, Lawrence said. Pairing this strategy with covered calls can help enhance income and mitigate risk by offsetting losses if the stock's price declines, he said. "Hence, we will lean more towards tailored active management versus an ETF," Lawrence added. "I think we will have a little bit of a pullback, but we can use options to be paid while we wait for the right entry point." Due diligence Get ready to do some homework if you're looking to incorporate options strategies into your portfolio. Here are a few starting points. Consider your priorities: If you like the aspect of additional income, but the prospect of growth is a must-have, a plain-vanilla dividend paying fund may be a better fit. Vanguard's Dividend Appreciation ETF (VIG) tracks companies that are boosting their dividend payments, while the ProShares S & P 500 Dividend Aristocrats ETF (NOBL) follows companies that faithfully pay and hike their dividends. "Instead of owning a covered call fund, you can buy a dividend fund that's paying 3% in dividend income," said John Rekenthaler, vice president, research at Morningstar. "It's still appreciating in price." Be tax conscious: Derivative income funds can bring tax complexity because they can spin out income that's subject to short-term capital gains treatment. That means they are taxed as ordinary income at a rate that's as high as 37%. You'll want to keep these funds in a tax-deferred account – like an IRA – instead of a taxable account. Comparison shop: Morningstar labels covered call funds and their ilk as "derivative income funds," but each offering will have its quirks, and this could affect its risk-return profile. "There are some fund categories that are more homogeneous than others and this isn't one of them," said Rekenthaler. "They're misunderstood because of their complicated strategies and the variation among them."