Covered-Call Funds: A Mystery Wrapped in an Enigma

Impressive Sales

Covered-call stock funds have become bestsellers. While almost all other actively managed equity categories recorded net outflows last year, derivative-income funds (to use Morningstar’s terminology for such funds) attracted $22 billion.

Derivative-income funds invest in equities, as do conventional stock funds, but then take an additional step. In one fashion or another—either by selling call options or buying equity-linked notes—they trade tomorrow for today, by accepting cash in return for forgoing some of their future stock market profits. The cash is the attraction. Investors prize the funds’ high ongoing distributions. (Sometimes the payouts are income, and sometimes they are capital gains.)

Unimpressive Performance

Despite their marketing prowess, derivative-income funds have not performed particularly well. My recent column showed that, over the past five years, most derivative-income funds have posted lower returns than have the dividend-stock and equity-income funds run by industry leaders Vanguard and Fidelity.

At the conclusion of that article, I offered three possible defenses of derivative-income funds. One was that measuring performance solely on total returns is incomplete; their risks should also be considered. Another was that the category’s largest fund, JP Morgan Equity Premium Income ETF JEPI, has performed very well. We can dismiss those two objections. Risk-adjusting the results does not change the conclusion. Meanwhile, JP Morgan’s fund owes its relative success to its first 18 months of operation, before most of its shareholders arrived.

The Bull-Market Rebuttal

The third counter, however, cannot be so easily dismissed. Because derivative-income funds concede capital growth, their worst relative performance occurs during bull markets. In theory, that is correct. As with other stock funds, the highest relative gains for derivative-income funds come when stock prices increase. But because derivative-income funds sign away some of their potential capital growth, they will likely trail traditional equity funds during such times.

In contrast, if stocks are languishing, derivative-income funds may well receive something for nothing. After all, they are paid to surrender their upside. If there is no upside, then derivative-income funds enjoy a free investment lunch. They eat the money they collected from selling call options (or the interest paid by their equity-linked notes) while ceding nothing in return.

It’s Complicated!

That argument makes sense. However, it assumes a streamlined model, where equities in unison either rise, stagnate, or fall. In practice, though, fund portfolios usually do all three. That is, even if the overall stock market is moping, many derivative-income fund positions will be increasing—and thus potentially called away. Similarly, during bull markets, some of the funds’ holdings will trail the averages, thereby preventing the call option from being exercised.

Further muddying the waters is the fact that, for derivative-income funds, the pattern of stock market returns is as important as the level. The more volatile that security prices are, the more valuable that call (or put) options become. Because derivative-income funds sell options, that bromide works in reverse for them. They struggle when market volatility increases and profit when it subsides.

Case Study Number One: The Mid-’80s

An example of the former occurred during the mid-’80s. At that time, funds that wrote covered calls did so mostly with bonds, as opposed to equities. But the same principles applied. If bond prices moved sharply in one direction and then the other, those funds could become two-time losers. They would suffer once when rising bond prices forced them to surrender their winners, and then again when they held their entire portfolio through the bond market’s decline.

That is exactly what happened. From 1986 through 1987, 10-year Treasury yields went nowhere. They exited the 24-month period at virtually the same amount at which they had entered it. Unfortunately for those option-selling bond funds, those endpoints were deceiving. Treasury bonds initially rallied for 14 months, during which the fund’s holdings were called away. Bond prices then sunk over the next eight months. Although the funds’ losses were cushioned by their call-option proceeds, their net asset values nevertheless dropped significantly.

That episode scotched the future of covered-call bond funds (which were officially named “government-plus bond funds” and unofficially dubbed by their disappointed shareholders “government-minus funds.”) They disappeared from the earth—or at least the U.S. fund market—for several decades.

Case Study Number Two: The COVID-19 Pandemic

In 2020, history repeated itself. This time, the surge in volatility affected stocks rather than bonds, and the fall preceded the rise, but the investment logic was identical. When COVID-19 sent U.S. equities to a 34% monthly loss, the revenues that derivative-income funds had received from selling call options proved scant consolation. Then, when stocks’ fortunes abruptly reversed, derivative-income funds missed much of the rally, as their stocks were called away. Whipsawed!

For the year, the S&P 500 index gained 18.4%, while the four derivative-income funds that are explicitly managed to the S&P 500 lost an average of 0.11%. Ouch!

Nor were the performances of those funds consistent. Unknowingly, their shareholders had participated in something of an investment lottery, as the calendar-year returns on those funds ranged from positive 7.30% to negative 3.66%. The upshot: There is no such thing as a predictable derivative-income fund. Not only do they perform differently from the overall marketplace, but even funds that track the same benchmark can also diverge widely. Derivative-income investors fly blind.

Conclusion

I don’t understand why investors have become so fond of derivative-income funds. Yes, of course, I realize that people like high distributions. What I don’t understand is why. Clearly, these funds do not receive something for nothing. They pay a price for those income/capital gains payouts—a price that can be readily measured with their total returns, which have been unspectacular. After all, we have been here before. At least in kind, the 2020 results for these funds resemble the 1986-87 period for disgraced government-plus funds.

None of which is to say that derivative-income funds cannot perform well. They can, under certain conditions. If those conditions persist for sufficiently long, such funds could indeed justify their purchases. But why invest on faith, especially when the returns on such funds vary so greatly, and when there is insufficient evidence to distinguish the category’s future winners from its losers? To that rhetorical question, I have no answer.

Happy Birthday!

Yesterday, Taylor Larimore turned 100 years young. Apparently, the former World War II paratrooper and author of The Bogleheads’ Guide to the Three-Fund Portfolio is in fine fettle. Here’s to many more years, Taylor! Perhaps during that time you will discover a fourth fund.