In a still-uncertain second half, advisors and investors remain in search of ways to boost income potential and portfolio diversification. The environment has favored options strategies, particularly covered calls that continue to bring in massive inflows, but most advisors and investors are missing out on the opportunity.
Given the enormous popularity of covered call strategies in the last few years, Tom Lydon, vice chairman of VettaFi, tackled everything covered calls alongside Troy Cates of NEOS Investments and Hamilton Reiner of JPMorgan Asset Management in the VettaFi Fixed Income Symposium.
Replay for the event is coming soon.
Covered Calls 101
So what exactly is a covered call? Covered calls entail holding an underlying security (or index) and then selling calls on that underlying security or index at a specific strike price on a specific date. The writer of the call earns a premium on the call.
“It’s a more passive way to invest,” explained Troy Cates, co-founder and managing partner of NEOS, co-portfolio manager of the NEOS ETFs. “It’s a more low-risk way to invest and use options — it’s usually the way that people first dive into their option experience.”
Covered call ETFs have existed for around a decade, initially in passive strategies, and exploded in popularity in recent years. The evolution of both covered calls and ETFs meant that increasingly more covered call ETFs that launched did so as actively managed funds.
“When you sell a covered call, you not only get the benefit of the income, but you also get the benefit of reducing volatility and beta,” said Hamilton Reiner, managing director, portfolio manager, and head of U.S. equity derivatives at JPMorgan Asset Management.
Covered call funds sometimes offer as much as 50% volatility and beta reduction to core benchmarks. “In a world in which markets are 18% year-to-date and people don’t believe it, it’s a way to get back into the market with less volatility and less beta,” Reiner said.
Where Covered Calls Fit Into Modern Portfolios
A second use case for JEPI and JEPQ is total returns. Both funds sell options out-of-the-money as part of their total return strategy that includes a varied income sources. Lastly, advisors and investors are using options in place of adding credit risk to their portfolio.
“We’re seeing people use it as a replacement for extending credit,” said Reiner. This includes “high yield, emerging market debt, preferreds, convertibles, because those strategies have a fair amount of duration.”
Looking ahead, Reiner said that advisors and investors will still employ the traditional 60-40 portfolio concept on a risk basis, but actual modern portfolio construction will likely look different.
Investors will build “portfolios that are much more 50-30-20. 50% stocks, 30% income, and then 20% strategies like mine and Troy’s,” Reiner explained. “These strategies are expected to have better Sharpe ratios than the market, less downside than the market, and they actually are an important part of portfolio construction.”
Investors Leaving Opportunity on the Table
When polled, 57% of attendees responded that they do not currently allocate to covered calls and are still researching. It’s a common trend, as options are often incredibly complexed, nuanced investment tools with a steep educational curve. Investing in strategies helmed by managers with a decade or more of experience can create confidence for advisors and clients alike.
That’s the case with NEOS, which is a pioneer in the buy-write ETF space. The (SPYI ) is similar to JEPI in that it writes out of the money call options, but it’s doing so on SPX index options.
“The overall goal for SPYI is that high monthly income, that upside appreciation with the S&P 500,” Cates explained. That’s alongside the overall goal of 10%-12% annual distribution.
JEPI aims for 7%-9% annual distributions, but in last year’s high volatility environment, the fund ended the year over 11.5%. JEPQ similarly offers 9%-11% annual distributions but ended last year over 15%.
Breaking Down the Tax Structure
Before diving into options and covered calls, however, it’s important for advisors to understand the different tax mechanisms at work in each individual fund. JEPI and JEPQ generate dividend distributions taxed as either qualified or ordinary, and the options income converts to coupons. Investors in the funds are issued 1099s.
SPYI on the other hand is built around tax efficiency of the distributions. The SPX index options the strategy uses are taxed as Section 1256 Contracts under IRS rules. Any options held at the end of the year are treated as if they’ve been held all year. This means any capital gains are taxed 60% long-term and 40% short-term, regardless of the length investors held them.
“We tend to use SPX index options wherever we can in our products, or index options in general,” Cates explained. Because of the preferential treatment these options receive, they prove beneficial come year-end taxes. In addition, part of the distribution can be classified as return-of-capital. Cates encouraged attendees not to think of it as a return of principal, however, but a constructive RoC.
For more news, information, and analysis, visit the Tax Efficient Income Channel.