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In my view, there is a fundamental human attraction to dividends. The concept of a “cash in, cash out” machine caters to the idea of entirely passive income. High dividend funds, stocks, and bonds have merits in many respects, often biasing toward financial assets with lower valuations. However, in other cases, investors are often drawn toward investment products with extremely high yields and few fundamental merits. High-yield assets can have a much higher risk. Still, they can also be somewhat deceiving by providing inconsistent dividends (very high, then meager) or paying out their capital as a “dividend.”
Over recent years, tremendous capital has been invested in “covered call” strategy ETFs. In my view, these funds are problematic because they deceive investors into thinking they’re earning a very high dividend yield when, in reality, they’re essentially being paid back their own capital. Hence, returns from covered calls are taxed as capital, not income. The “premium” received on a covered call is not akin to rent or interest but a payment received to compensate for the loss of upside potential while still incurring downside risk. It is most similar to selling insurance. If your insurance provider spent all of your premiums as personal income, it would be unable to cover you. For the same reason, investors who use covered call selling purely as an income strategy will ultimately lose their initial capital.
Furthermore, I believe covered call selling is relatively unattractive from a risk-rewards standpoint in the current market environment due to growing market tail risk potentials. I covered this issue in June in “RYLD: VIX Index Suggests It Is The Worst Time To Sell Options In Years.” Since then, RYLD has lost 9% of its value (5% if including dividends), and, to me, its risk-reward tradeoff has become considerably more alarming. As the Russell 2000 pushes against its crucial support level, RYLD will not benefit if it bounces up but potentially face ample losses if it breaks lower.
Covered Call ETFs Do Not Pay Real Dividends
Fundamentally, all “covered call” ETFs do not pay an actual dividend; they pay capital out to investors as a distribution. As such, most, such as the popular Global X Russell 2000 Covered Call ETF (NYSEARCA:RYLD), produce very high “yields” of 15.6% (for RYLD). However, the true “dividend” from an SEC definition standpoint of RYLD is just 1.27%. Investors who constantly reinvest their distribution into RYLD should ultimately earn a return akin to the iShares Russell 2000 ETF (IWM), albeit with better performance in stagnant periods and weaker performance in bull markets.
However, investors who cash out distributions for RYLD should expect to lose all of their capital over a sufficiently long period. That is not a prediction but a statistical fact stemming from the covered call’s limits on the upside and lack thereof of downside. As long as stocks rise in a bull market, a covered call ETF’s capital value should be relatively constant. At the same time, its total return, including reinvested dividends, should be similar to the market’s. However, when the market is stagnant or declining, RYLD will tend to lose value but never totally recover, eventually leading to a complete loss of the initial investment. The decay rate is not shown well in RYLD’s value because the Russell 2000 performed well in 2021. However, RYLD’s value relative to the Russell 2000 shows the decay factor very clearly:
From a relative value standpoint, we can see how RYLD has nearly identical downside as the iShares Russell 2000 ETF (IWM), losing considerably in 2020 and 2022. However, we can also see how it does not recover with the Russell 2000, as seen in 2021, leading to an inevitable complete decay. The relative decay factor of RYLD to IWM is about 10% annualized over its history, meaning investors in RYLD should reinvest at least ~2/3rds of the dividends they receive if they want to avoid losing their capital over time.
The overwhelming majority of comments I’ve received in articles regarding covered call ETFs are from retired investors who admire these vehicles for their deceivingly high dividends. I say “deceivingly,” not because RYLD’s managers are being deceptive (relatively honest about its flaws) but because of the self-deception from investors in these funds who confuse option premiums for income. Option premiums are capital payments to offset the significant risk taken on by call sellers. That is, they offer market downside protection while foregoing all market upside (given its strikes are set “at the money”). Again, as an investor in RYLD, you are insuring others against market risk; thus, if you spend those premiums, you will slowly lose your initial capital over time.
The Merits of RYLD in the Current Environment
To me, the issue with RYLD is that it attracts unsuitable investors who are likely looking for a long-term income strategy. Such investors would be better off in high-dividend stocks and bonds, with 5-6% money market funds likely being the best risk-reward bet today. Unlike call selling, such assets pay a high yield while generally preserving capital. In the current high-rate environment, income investors have a massive advantage by investing in short-term bonds, which have never been as attractive as they are now since ~1999. Fundamentally, with high interest rates, there is no need to compromise risk for a higher yield, considering virtually risk-free assets are paying 5-6%.
RYLD, or other call-selling strategies, can benefit investors who truly understand how they operate in differing circumstances. Call selling also results in inconsistent dividends that vary with market risk perception. RYLD usually pays a higher dividend when risk perception is high because demand for market risk “insurance” is higher. Of course, market risk perception does not necessarily equate to actual market risk, as market risk often rises the fastest when investors least expect it.
Covered call selling offers minimal but some protection against downside risk by having a monthly “premium” of around 1% as a buffer against losses. However, in market crashes that are often 10-30% per month, a 1% buffer will not make a huge difference. However, after crashes, when risk perception is very high (as seen in the VIX), that premium level can rise to 2-3% per month, offering a very high return. RYLD’s best performance was following the 2020 crash if we assume reinvestment of all distributions (or “total return”). See below:
Of course, RYLD will not gain the capital “re-appreciation” of the underlying index after the market crashes during rebounds. Thus, while its best returns should be seen during “high VIX” rebounds, its best returns relative to its index are often seen in calm periods. This is illustrated in its total return relative performance to the Russell 2000 ETF IWM, compared to the spread between the Russell 2000 “VIX” (or “RVX”) minus historical volatility in the Russell 2000. See below:
From 2021 to 2022, the RVX was consistently more significant than the actual volatility on the Russell 2000. In other words, the “risk premium” on Russell options was high compared to the actual risk assumed by option sellers, leading to outperformance for RYLD. The opposite was true during 2020 when volatility was much higher than expected. During the 2020 crash, the derivative market temporarily broke down, leading to a ridiculously high VIX of 82.7, as market risk insurers nearly failed and were forced to buy back options. Notably, the VIX hit an all-time low in January 2020, which was re-touched over recent months, highlighting how risk perception does not equate to risk reality.
The Russell 2000 is the most economically sensitive index, with a strong correlation to the manufacturing PMI, which measures likely future changes in industrial growth. Currently, the manufacturing PMI is at 46.7 and has been below 50 for the entire year, indicating declines in US industrial activity. The PMI also fell last month after some signs of recovering, potentially indicating a more significant slowdown. This change is reflected in the Russell 2000:
The Russell 2000 is currently sitting on the support level it has held for around the past eighteen months. That fact and the weak manufacturing PMI may indicate a more considerable decline for the Russell 2000. The “P/E” valuation of the Russell 2000 is very low at 10X, but that may also indicate it is a “value trap” as its holdings’ incomes are declining with the manufacturing sector.
I remain neutral on the Russell 2000 because of its substantially lower valuation than other indices. It behaves like a recessionary crash is somewhat likely; however, it is also discounted and trading at a support level that could result in rebound capital appreciation. However, for this reason, I am very bearish on RYLD because it will not benefit from a potential rebound. The RVX is at ~21.4%, which is below its normal level, meaning premiums received from such a bounce will be pretty low, while it cannot earn any direct capital benefit from such a rebound. At the same time, if the Russell 2000 breaks lower, RYLD will suffer nearly identical losses with minimal “buffering” due to the low RVX level. Thus, to me, RYLD is quite literally a “high risk, no-to-low reward” trade in the current market environment.
The Bottom Line
Covered call strategies have a time and place for investors focused on obtaining alpha. Mostly, covered call ETFs are most likely to outperform when public fear around markets is high but actual market volatility is low. In that environment, the “insurance premiums” exceed actual risk. However, today, we’re seeing high actualized volatility in the Russell combined with higher risk due to the manufacturing macro trend but extremely low premiums to compensate for that risk. Thus, I believe RYLD is an inferior investment option in the current environment and will likely underperform the Russell 2000 over the coming quarters.
Furthermore, RYLD is unsuitable for income-oriented investors because it will inevitably lead to capital decay, and its dividend will ultimately decline in line with its decay rate, making it only suitable for investors willing to reinvest at least around two-thirds of the distributions received by the fund.
