Covered call ETFs are relatively new and literature on the internet provide little insights on how such an asset is good for investors. Hence, this post hopes to add knowledge to whoever is interested. First we need to cover the following sub-topics to understand this idea better.
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What is a covered call ETF?
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Why buy on the London Stock Exchange or LSE?
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What is the thesis?
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What are the risks?
First up, a covered call is an option which allows the seller to sell a stock which he or she owns, usually at a higher fixed price vs today some time in the future. This allows the seller to receive a premium from the buyer. Call options give the buyer the right to buy a stock at a certain price (i.e. the seller has the obligation to sell at that same price)
There is also something known as a naked call, when the seller doesn’t own the stock. But that is a topic for another day. Today, let’s discuss the thinking for the buyer and seller of call options:
The call option buyer thinks it is good bargain to buy a stock at a certain higher price but doesn’t want to pay up for it. So he wants to only buy the right (i.e. the call option) which is much cheaper. In a way, call options provide stock buyers leverage. He is bullish on the stock.
The call option seller (i.e. us) is obliged to sell at this higher price, but in return, receives a premium. He doesn’t want to sell the stock now but at a certain higher price, he is okay to sell. On top of that, he receives a premium and is therefore even happier. In a way, the seller is bearish but not bearish enough to sell today.
Covered call ETFs
Now that we have covered covered calls. We can go on to how it works for an ETF. So extrapolating form the above, the Nasdaq 100 covered call ETF will own the 100 Nasdaq stocks but sell covered calls on them. In the US, this goes by the ticker QYLD and in UK, the author would be buying QYLP which is part of the group of ETFs listed in 2022 with the same manager Global X but this particular ticker is denominated in pounds. The reasons shall be discussed in the next section.
This ETF essentially owns names of the Nasdaq and sells covered calls on them to generate returns. The list of names, which are publicized regularly and differs in weightage vs the index, are as follows:
The US listed entity has a much longer history and we can see from the below that the track record is not far from the index return assuming that all proceeds are reinvested. Since inception (which was 2013), the ETF has returned 7.4% while the index returned 8.3%.
Yes the ETF return is actually lower than the index, so shouldn't we buy the index? This too shall be discussed below in the thesis section. For now, let's call that covered call provides premium to the owner and is less volatile than the index. Covered call ETFs generate very high dividend and this particular one, QYLP has provided 11-12% dividend since inception (which was 2022 on the London Stock Exchange).
This is a good segue to go into the next section.
Why the London Stock Exchange (LSE)?
The reason is that UK has no withholding tax. So the 11-12% goes directly into investors' pockets. If we have bought the US listed one, 30% would be taken away by taxes which makes it less interesting. The author has chosen the GBP denominated one because of future currency needs but most investors should just use USD, which is the default currency and that means less complications.
The dividends come monthly and has been very beneficial for many retirees. Some people have invested in covered call ETFs for decades and benefit from the monthly income. Notable ones include DIVO and JEPI which interested readers can also dig into from the link below.
https://moneyguynow.com/best-covered-call-etfs/
Thesis and Risks
Okay, let's discuss the main topic. Thesis and risks. Why buy such a complicated instrument when we can buy the index. The answer is that in other times other than 2024, you should probably buy the index. Index buying has been proven to be the easiest way to compound returns and dollar cost averaging into index buying will create good wealth over time. The index of choice will be the S&P500 which has returned c.11%pa over the last 10 years and more than 10%pa over the last century.
So why bother with covered call ETF on the Nasdaq?
Here's why:
- We don't want to miss out on the tech and Gen AI bubble.
- The regular income is good.
- Covered call ETFs will outperform if the market is flat or if it goes down.
There is real upside risk that we are at in the middle of yet another tech bubble which is driven by the Magnificent Seven, Generative AI and perhaps cryptocurrency (again!). Yes these names have rallied a lot but it seemed that we are not in the final legs of any huge bubble. It could go up a lot more from here and we stand to miss all the upside from here.
If you owned Nvidia when it was below $100 and has rode the stock up, then good for you and perhaps this idea is not for you. But for most of us, this might be a good way to participate without taking on all the risk. The covered call ETF owns the underlying names and will go up as long as the index goes up. It also provides regular income. However, it will underperform the index over the long run due to higher expenses,
This brings us to the second point which is the monthly dividend. Covered call ETFs provide regular income which is very attractive for people who require this. As mentioned, for QYLP listed on LSE, this is 11-12%pa which is very significant.
The last point is simply a reiteration that we are hedging ourselves should this bubble scenario not play out. If Nasdaq collapses, then we are saved by the dividends and should outperform, at which point, we should then actually buy the index like QQQ or SOXX.
Let's talk about the risks!
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