Episode 375: Covered Calls: A Devil's Bargain

Episode Summary

Executive Summary: In this episode of Rational Reminder, hosts Benjamin Felix and Dan Bortolotti critically examine covered call ETFs, arguing that these products offer a "devil's bargain" by marketing high distribution yields that are inversely related to expected returns. They explain how covered calls cap upside while leaving downside unprotected, eliminate the mean-reverting tendencies of stocks, and historically underperform simple buy-and-hold strategies. The hosts present data from live funds showing persistent underperformance, especially since 2011, and caution that these strategies primarily exploit behavioral biases for income rather than providing genuine investment value.

Main Topics: Mechanics of Covered Calls (Priority: 5/5): Explanation of how call options work, using a $20 stock with a $22 strike price example. The seller collects premium income but caps upside potential while retaining full downside risk. Distribution Yield vs. Expected Returns (Priority: 5/5): High distribution yields (e.g., 14%) are misleading and inversely related to expected total returns. Higher yields come from selling options with lower strike prices, which further reduces equity exposure and expected returns. Elimination of Mean Reversion (Priority: 4/5): Covered calls strip away the mean-reverting property of stocks, which is crucial for long-term investors. By capping upside while preserving downside, these strategies fail to capture market recoveries after downturns. Live Fund Performance Analysis (Priority: 5/5): Analysis of real covered call ETFs (BMO, Global X, JEPI) shows persistent underperformance relative to their underlying equity indices. Annualized trailing returns range from 2.6 to 5.92 percentage points, with underperformance in 70-92% of rolling periods. Volatility Risk Premium (Priority: 3/5): The theoretical benefit of collecting the volatility risk premium has not materialized since 2011, likely due to crowding from retail funds. The premium is now insufficient to offset lost equity exposure. Single-Stock Covered Call ETFs (Priority: 4/5): Extreme examples like TSLY (Tesla covered calls) show absurd distribution yields (48.59%) that result in catastrophic underperformance (over 20% annualized). These products are characterized as speculative tools rather than investments. Behavioral Biases and Regulation (Priority: 3/5): Income preference is a strong behavioral bias exploited by fund companies. The hosts criticize marketing that compares covered call yields to Treasury yields as misleading, calling it "financial bullshit" that shows indifference to the truth.

Key Arguments: Covered call strategies are mechanically expected to underperform their underlying equities because they cap upside while keeping downside risk. Higher distribution yields on covered call funds signal lower, not higher, expected total returns—selling options with lower strike prices increases yield but reduces equity exposure. These strategies eliminate the mean-reverting behavior of stocks, which is especially harmful for long-term investors who depend on recoveries after market downturns. Historical performance of live funds since 2011 confirms theoretical predictions: covered call ETFs have underperformed their indices by 2.6-5.92% annualized with high consistency (70-92% of rolling periods). The volatility risk premium, once a potential offset, has been insufficient since 2011 due to overcrowding in options markets. A combination of 60% underlying equity and 40% cash can replicate the risk/return profile of covered call funds more efficiently and with better investor outcomes. Marketing these products purely on yield, especially comparing to Treasury or bond yields, is fundamentally misleading and exploits investors' preference for income.

Data Points: BMO Covered Call Utilities ETF trailing return vs underlying: 2.6 percentage points annualized since inception (October 2011) - Underperformance despite 7.37% distribution yield vs 3.43% for underlying BMO Covered Call Canadian Banks ETF trailing return vs underlying: 2.71 percentage points annualized since inception (January 2011) - Outperformed underlying in less than 1% of 3-year rolling periods Global X S&P/TSX 60 Covered Call ETF trailing return vs iShares TSX 60: 3.65 percentage points annualized since inception (March 2011) - Underperformed underlying in 92% of 3-year rolling periods JEPI trailing return vs S&P 500: 5.92 percentage points since inception (May 2020) - Despite 2022 outperformance of ~15 percentage points, total return has lagged significantly TSLY distribution yield vs total return: 48.59% distribution rate, but underperformed Tesla by over 20% annualized since November 2022 - Extreme example of yield not reflecting return Average MER of covered call ETFs vs underlying: 0.63% vs 0.25% - Plus 0.16% trading expense ratio vs 0% for underlying ETFs

Pivotal Quotes: "The idea that covered calls generate income is financial bullshit. These strategies are mechanically expected to underperform their underlying equity and increasingly so at higher targeted levels of distributions." — Benjamin Felix: Opening argument establishing the episode's critical stance on covered call products "For long-term investors, covered calls, in my opinion, increase risk by leaving the downside unprotected or mostly unprotected while capping the upside. And that eliminates the mean-reverting behavior of stocks, which, particularly for long-term investors, is a really important feature of stock returns." — Benjamin Felix: Explaining the fundamental problem with covered calls for long-term investors "Selling these products on their yield, marketing them on their yield, which in the case of covered calls is inversely related to the strategy's expected returns, shows indifference to the truth. I'll say the word for real this time. It is bullshit." — Dan Bortolotti: Direct criticism of fund companies marketing practices, echoing the hosts' central theme

Implications: Long-term investors should avoid covered call ETFs, as they systematically destroy value through capped upside and unprotected downside. Regulators should scrutinize marketing that equates option premiums to bond yields. Simple portfolios combining stocks and cash achieve better risk-return profiles without the complexity and hidden costs of these structured products.