Covered call funds are bad investment for the risk
Taking advantege of Blossom on desktop to write a longer post :) WHAT ARE COVERED CALL FUNDS? I’ll keep this section short as this will be a long post. Covered call funds hold stocks (or have synthetic position) and sell call options on these stocks. Selling options generate premium that provides income, but limit upside. I personally like the idea. I really do. So I read a lot about this topic and found out these funds are, unfortunately, bad investments for the risk. I’ll show you why. YIELD IS NOT GAIN – TOTAL RETURN IS WHAT COUNTS First, let’s clarify one thing: distribution and distribution yield is NOT gain. Funds can distribute what they want, they can even distribute more than what they earn and many cc funds do. I can start a fund today, invest in nothing and distribute 5% every quarter so 20% annualized. You invest $1,000 and I’ll distribute $50 every quarter. I won’t miss one quarterly payment for the first 20 quarters. Best fund ever! You understand that this is a bad investment, despite a 20% distribution yield and 5 years of constant payouts, right? That’s because you understand there is no gain - total return is 0% -as I’m just returning you your own money. Well this is the same when you look at any fund: distribution doesn’t mean profits. To know how much gain a fund made, you must look at its total return. Total return includes all distributions and fund value variation (or share price) THEY ARE NOT RISK FREE Covered calls funds hold shares of the stock they sell calls on. This means they are exposed to the same downside risks as the stocks they hold. If the stocks they hold go -40%, the fund NAV will also go -40%. (Same for funds with synthetic position selling puts) THEY UNDERPERFORM THEIR UNDERLYING When researching covered call funds, I found that every single cc fund underperforms its underlying. Covered calls funds aren’t new, so we can look at the performance of funds launched more than a decade ago. $QYLD was launched in 2013 and sells covered calls on $QQQ . Since its inception, if you would have invested $10,000 in $QYLD and had reinvested all dividends to buy back shares of $QYLD, you would now have $16,440 for 4.4% annualized return. If you would have instead just bought and held $QQQ, you would now have $48,908 for 14.5% annulized return. That’s a 3 folds difference after 12 years. 3 folds! https://totalrealreturns.com/s/QYLD,QQQ Same goes for high-yield funds from YieldMax: $10K in $TSLY = $11.7K or 6.5% CAGR $10K in $TSLA = $17.5K or 25.0% CAGR $10K in $MSTY = $35k or 168% CAGR $10K in $MSTR = $50K or 255% CAGR LESS RETURN FOR SAME RISK: AN INVESTMENT CARDINAL SIN A core principle of investing is: For any given level of risk, you should seek the highest potential return. Knowing these funds have the same risk level as their underlying but underperforms their underlying makes them bad investments. This is the MOST IMPORTANT point of that post: no one should ever accept less potential return for the same risk. Period. There is no scenario for which accepting less return for same risk makes sense. Think about this one more time: you KNOW one product will overperform another product, why would you pick the underperforming one? It makes absolutely no sense. The post should end here as this argument is enough, but I’ll add a few more points about the arguments I’ve heard on Blossom. #1: I don’t care it underperforms, I just want to make a constant and predictable 18%. Wouldn’t we all want a predictable 18% CAGR return? But markets returns have been about 8-10% historically, so there is no funds that can have a predictable 18% return. Much less funds that have strategy that underperforms just holding stocks. 18% CAGR would compound $100K into $126 millions in 40 years. No underperforming fund would give such returns. #2: I just want monthly income with low risk. These funds hold stocks (or hold long positions). They have the same downside risks as their underlying. And many of the popular funds holds only 1 volatile company. It’s the very opposite of low risk. Accepting lower potential return for less risk is an acceptable investment trade-off. But these funds aren’t risk-free fixed income products. It comes down to the most important point of the post : these products have the same risk, but lower return than their underlying. #3: I need money You can consistently sell shares. Since the underlying overperforms the cc fund, you would end up better by selling shares of the underlying vs holding the cc fund #4: I don’t want to sell shares during a downturn. This is a legitimate concern, but cc funds aren’t a solution. You may not sell any shares of the covered call funds, but the fund will. Take $QYLD, it was launched at $25.00 and $QQQ was then trading at $85.00 So 1 share of QYLD was holding 0.29 share of QQQ. QYLD is now at $16.37 and QQQ is at $519. So 1 share of QYLD is now holding 0.032 share of QQQ. So QYLD sold 88% of its shares since inception. Every time a cc fund share price doesn’t follow the underlying share price, it mathematically means it holds less shares of it. #5: I don’t like to sell shares This is a personal bias you need to work on. Overcoming that bias may mean multiple folds more return over the years. It’s more than worth it. #6: Every investor can invest in what they want, to each their own. Sure! But that doesn't make these fund good investments, and people should not recommend these funds to others. #7: I’ve doubled my money with $MSTY, how do you explain that? The point isn’t that you will lose all your money with cc funds. The point is that you would just make more money holding the underlying. If you can guess which stock will go +300%, just buy that stock! #8: I want tangible money, not paper gain Again, distribution isn’t gain. If a fund gives you $100 but its value goes down $100, you didn’t make any gain. Plus the event that gives you spending money isn’t when you get distribution: it is when you withdraw money from your investment account. And it doesn’t matter then if the money comes from dividends, distribution, interest or selling shares. It really doesn’t. TLDR: - The idea of covered call funds is good. - The problem is that all these funds underperform their underlying for the same downside risk. - It’s against all core principles of investing to accept lower potential returns for same risk. - This makes these funds bad risk adjusted investments. EDIT: As requested I made posts comparing real life examples of cc funds vs underlying. Very detailed monthly spreadsheets. $TSLY vs $TSLA : https://link.blossomsocial.com/7uYa/2fez41wz $CONY vs $COIN: https://link.blossomsocial.com/7uYa/n1o97wxn
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252 Comments
Perry's PIIverse@piiverse · 1yr
We just have to agree to disagree. Your perspective is skewed so you can't see the light. But that's ok. You follow your growth strategy if it works for you. Happy investing.
John D@iamjohn_d · 1yrEdited
One aspect of ETF investing that I think people often forget is that fund managers are also in the business of making money. Covered calls are not a new strategy, they’ve been around for quite some time, and fund managers—particularly the smaller ones like Hamilton, Harvest, and Evolve—have done an excellent job at marketing these products to retail investors. For retail investors, I think you want to find fund managers that create products with the goal of making money WITH you, not FROM you. With the high fees charged from the active management, the poor risk-reward profiles, and the long-term underperformance, covered call fund managers appear to be more closely aligned with the ladder—making money from you. With the indexing market being quite saturated with thousands of products, it shouldn’t come as a surprise to see fund managers engineering new ways to draw in new money into their business. In recent years, this “new” idea has been covered calls. So why are covered call ETFs so popular on Blossom? — I think it really comes down to a mix of 1) good marketing, 2) physiological appeal, 3) financial literacy, and 4) influencer following. The average Canadian investor has pretty low financial literacy and so when you come up with a product that offers a juicy 50% yield, then market it as a lower risk way to generate consistent, “passive” income that could change your life, of course it’s going to attract interest. Crazy that these funds raise no alarm bells or red flags to some investors. I guess it all comes back to their level of financial literacy and critical thinking skills. Thank you for making this post and pushing back on this bad investment strategy.
Omar @ihacked · 1yr
Remember Warren Buffet's famous quote: "Sell all your high quality stocks and buy CC ETFs"... Yeah, there's a reason the best investors in the world don't own them. Nothing profitable on a CC ETF yielding 30% with a -20% drawdown when the underlying asset returned 40%.
Michael Conroy@conroy119 · 1yr
Good post with logical arguments! Unfortunately, the people who are 100% invested in these are the equivalent of those who believe the earth is flat. Flat earthers. You can present them with facts and logic, but it doesn't resonate.
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