Covered-Call and Buffer ETFs: Stock Investing With Less Gain but Less Pain

Key Takeaways

• For covered-call ETFs, you basically have exposure to an underlying stock position and then you sell a call option against it, which caps your upside a little bit but gives you some income in the near term. With a defined outcome ETF or buffer ETF, you’re adding a put spread on top of that, which means you buy a put at the money and then you sell another put below that.
• These strategies designed for mostly preretirement or retirees that are looking for income or smoother returns.
• In general, the opportunity cost is large for covered-call and buffer ETFs.
• For covered-call ETFs, you’re turning more of your total return into income, that’s taxed as ordinary income, which is at a higher tax rate than capital gains.
• The original buffer ETFs were priced higher than what’s currently on the market. So fees have actually come down, so you can get a reasonably good buffer ETF for 50 basis points or less. For covered-call strategies, it’s more competitive.

Ivanna Hampton: How much gain would you be willing to give up in exchange for some peace of mind? Some investors are making this trade-off for some predictability. What should you know before adding covered-call and similar ETFs to your portfolio? Bryan Armour is the director of passive strategies research for North America for Morningstar Research Services. He’s also the editor of Morningstar’s ETFInvestor newsletter. Thanks for being here, Bryan.

Bryan Armour: Thanks for having me.

What Are Covered-Call ETFs and Buffer ETFs?

Hampton: So you’re moderating a panel about option-based funds at the Morningstar Investment Conference in June. Can you explain what covered-call and defined outcome ETFs, aka buffer ETFs, are, and how do they work?

Armour: Both incorporate options in their strategy, but the similarities end there. So for covered-call ETF, you basically have exposure to an underlying stock position and then you sell a call option against it, which caps your upside a little bit but gives you some income in the near term. With a defined outcome ETF, or buffer ETF, you’re adding a put spread on top of that, which means you buy a put at the money and then you sell another put below that. And then for that little piece, maybe 10%, you don’t partake in any of the losses of the index. So when stock market drops 10%, you won’t lose anything, but after that, if it continues to go down, you will. And the way that you pay for that insurance to some extent is by selling the call in the same way that you would a covered-call ETF.

Hampton: So it requires some monitoring.

Armour: Yes, absolutely.

Who Are These Strategies Designed For?

Hampton: What kind of investors are these strategies designed for?

Armour: I would say mostly preretirement or retirees that are looking for income or smoother returns. It really is a way to hedge some of the volatility of an all-stock position. So in some sense, especially with the buffer ETFs, it would be designed more like a balanced fund rather than a covered-call, which is effectively just a way of almost like trading in some risk for income.

Why Investors Are Adding Covered-Call ETFs and Buffer ETFs to Their Portfolios?

Hampton: Now more money has been flowing into these funds. Why are investors adding them to their portfolios now?

Armour: There are risks in the market. We’re seeing a lot of concentration at the top of the S&P 500, for example. And people are worried that we might be in another bubble. To some extent, it could just be inertia from 2022 when people were looking for any source of yield that they could find and bonds weren’t really an option in a rising interest-rate environment. But it’s a good way to take some of the risk off. But obviously, that income you get doesn’t cover much if stocks do go down. So, it’s something that investors need to be cognizant of.

What Are the Downsides of Covered-Call ETFs and Buffer ETFs?

Hampton: Well, let’s flip it: What are the downsides? Spell them out.

Armour: The main one’s opportunity cost. So if the index goes up past the call option’s strike price, you don’t get any of those gains. For most investors—the reason why I said it’s more for retirees—most investors, they can weather some of that volatility over a long term, decade, five years, 20 years, whatever it may be. You can handle some of that volatility, a drawdown, and still make the long-term higher returns. But with a retiree where you’re withdrawing money, it becomes more important the sequence of your return. So you’re willing to shed some of that return in order to cut down on volatility. So that’s really where that trade-off comes from. But in general, the opportunity cost is large. Like stock market has what we call fat tails in the distribution of returns, which basically means there tends to be extreme performance on either side, negative or positive performance. And so when you have in either case—a covered-call ETF or a buffer ETF—you sort of keep exposure to the bad tail to some extent and you give up exposure to the good tail.

Tax Concerns for Covered-Call ETFs

Hampton: Bryan, are there any tax concerns?

Armour: For covered-call ETFs, there are. So because you’re turning more of your total return into income, that’s taxed as ordinary income, which is at a higher tax rate than capital gains. So if you were to hold this for a longer-term period, you’d be paying higher taxes than selling off capital gains. For buffer funds, for the most part, there isn’t as much income because you’re sort of offsetting the premium received from the call by paying for the puts. So there’s not as much of a tax concern there.

What About Fees?

Hampton: That’s very visual. I got to ask you about fees. I feel like every time you come here, we talk about fees. Can you talk about what these ETFs are costing investors hoping to shield themselves from volatility?

Armour: We always talk about fees because best predictors, future success, right? The original buffer ETFs were priced higher than what’s currently on the market. So they were 75 basis points, 1% somewhere in there, roughly were the fees. But since then, we’ve seen new entrants: iShares has entered, J.P. Morgan, Parametric to name a few. And so fees have actually come down, so you can get a reasonably good buffer ETF for 50 basis points or less. For covered-call strategies, it’s more competitive. The poster child is JPMorgan Equity Premium Income ETF JEPI, which is a massive ETF but charges 35 basis points. We’ve seen some new entrants follow a similar strategy for a little bit less, so you could get 27, 28 basis points instead.

Hampton: Bryan, you and your panelists will go deeper into this topic at the Morningstar Investment Conference. Everyone listening and watching, check out the show notes for a link to register. Bryan, thank you for coming back to the table.

Armour: Thank you so much for having me.

Watch more from the Morningstar Investment Conference 2024 here.