3 Common Covered Call ETF MisconceptionsÂ
These are the three biggest misconceptions I see on here when it comes to covered-call ETFs.
I call them misconceptions because the fund companies themselves do not make these claims and, in many cases, their own material directly contradicts them.
Fund companies are actually pretty clear on this. They consistently remind investors that yield is not the same as return, and that total return is the number you need to look at when evaluating how an investment is actually performing.
So with that said, here are my top three.
1. A higher yield means you can spend more
I put this at number one because I see a lot of people looking at the yield of a fund and making investment decisions based largely on that number. A higher distribution yield means more cash is being paid out per dollar invested, but it does not mean the investment is earning a higher return.
A fund yielding 12% can still produce a lower total return than a fund yielding 4%. That is the distinction people need to understand: cash flow and investment return are not the same thing.
A lot of people seem to assume that a higher yield automatically means they can spend more than a traditional 4% withdrawal rate. That conclusion is not supported by math or the fund companies themselves which consistently point investors back to total return, because that is what ultimately determines how much a portfolio can support over time.
2. If you sell shares, you will eventually deplete your account
This one gets repeated all the time, usually because people focus on the number of shares being sold instead of what is happening to the total value of the portfolio. Selling shares is not automatically the same thing as consuming your capital. What determines that is the relationship between your withdrawals and the total return of the investment, not the yield. If your investment earns a 10% total return and you withdraw 6%, you can still end the year with more money than you started with.
You may own fewer shares, but the shares you still own can be worth more. That is really no different from owning a covered-call fund that pays a large distribution and then reinvesting part of that distribution to maintain or grow your capital.
Fund companies themselves make this point. Recently, Olivia Li, Portfolio Manager at BMO ETFs who manages covered-call funds, stated: âYou can create essentially the same cash flow by investing in the underlying index and periodically selling a small portion of your holdings.â
Jay Pestrichelli, Chief Trading Officer at Tidal, has made the same broader point: yield does not equal return, and investors need to look at total return when evaluating these products.
If the investment earns more than you spend, your capital can grow. If you consistently spend more than the investment earns, you are consuming capital. It does not really matter whether that money arrived as a distribution or because you sold a few shares.
3. Covered calls let you retire with less
This last one is probably the easiest to separate from what the fund companies actually say, because you will not see them promoting this idea. It is entirely a retail-investor claim. There are some people that argue that covered-call funds allow someone to retire with less money saved simply because the fund pays a larger distribution. But a 15% distribution does not suddenly give a smaller portfolio the same spending power as a much larger one. Someone with a $500,000 portfolio earning a 15% distribution is not automatically in the same position as someone with a $1 million portfolio simply because the cash yield is higher.
The distribution rate tells you how much cash is being paid out. It does not, by itself, tell you how much the portfolio can sustainably support over time. There are no fund companies that are out there pushing this narrative or supporting it and when they are asked they bring the conversation back to total return.
Those are the 3 big misconceptions that I see people spreading. In the end total return tells you what the portfolio earned. If you donât want to spend down your portfolio you have to spend less than the total return.
Covered calls change how the cash flow is delivered. They do not change the mathematics of total return.
There are plenty of reasons people choose to be income investors, and many of them are perfectly valid. For anyone looking seriously at income investing, I highly recommend reading The Income Factory and spending some time reading or listening to interviews with the people who actually manage these funds.
One of the things you will quickly notice is that many of the more outlandish claims made about income investing are not coming from the fund managers themselves. Now I imagine there will be people who disagree with this, and for those people I would say: go directly to the fund company and ask them.
Does a higher distribution rate, by itself, allow you to sustainably spend more?
Is selling shares inherently worse, from an economic standpoint, than receiving the same amount of cash through a distribution?
Can a covered-call fund with a higher distribution allow you to retire with a smaller portfolio?
And share the answers they give below !
