ICAP - DIVO Remains Our Number One Covered Call ETF

2023-08-08 12:25:19 ET

Summary

• Covered call ETFs perform well when equity markets are in an uptrend and the VIX is high.
• I believe DIVO is a top-performing covered call ETF, followed by JEPI.
• ICAP, which uses leverage, has higher risk and lower returns compared to DIVO and JEPI.
• Our favourite covered call ETF remains DIVO. JEPI is a close second while we keep advising to avoid ICAP.

The JPMorgan Equity Premium Income ETF ( JEPI ) is much bigger than the Amplify CWP Enhanced Dividend Income ETF ( DIVO ), but we have shown a preference for DIVO and this is still the case. Stay tuned to find out why.

Past performance

Covered call writing is a defensive, low(er) beta, strategy. When the markets rise, you get a nice return. That return will probably be lower than the return of the equity markets itself, but that's something you know in advance.

When the equity markets fall, you outperform thanks to the collected option premiums. Of course, when the markets really tank, you will still have a negative return. That's why we prefer not to invest in such a strategy when the equity market is in a long-term downtrend.

The first thing we notice when we look at the past performance of covered call ETFs is indeed: the better the performance of the "underlying" index, the better the performance of the covered call ETF.

The Nasdaq has outperformed the S&P 500, which in turn did better than the Russell 2000. We see this performance reflected in the passive Global X covered call ETFs. The Global X NASDAQ 100 Covered Call ETF ( QYLD ) outperformed the Global X S&P 500 Covered Call ETF ( XYLD ) and the Global X Russell 2000 Covered Call ETF ( RYLD ) is the laggard. Global X covered call ETFs buy the complete underlying index and write calls every month on the index.

That's why we prefer not to invest in a covered call strategy when the equity market in general and the underlying index, in particular, is in a long-term downtrend. When the equity market really goes down, a covered call strategy can't shield you from a negative return. This is not the case now. Rising stock markets are a tailwind for covered call ETFs.

When we look at the actively managed covered call ETFs DIVO outperforms JEPI. Not to our surprise , the InfraCap Equity Income Fund ETF ( ICAP ) has the worst result of all covered call ETFs.

DIVO is more actively managed, both concerning the stock selection and the call writing strategy. DIVO buys 20 to 25 high-quality large-caps with a history of dividend growth, along with a tactical covered call strategy on individual stocks. Based on market observations and income targets, the portfolio managers use a rules-based set of triggers to identify the best covered call opportunities on the stocks in their portfolio. They look for opportunities to write covered calls when the VIX is at 15 or higher. And the higher the implied volatility, the higher the premiums you can collect when writing options. DIVO aims for call premiums that will yield them 2 to 4% on an annual basis.

With the low level of the VIX, DIVO is less inclined to write calls and the result is a reduced upside potential limitation (that comes with writing covered calls). Another result is of course less premium income. The higher participation in the stock markets certainly contributed to DIVO's nice performance. DIVO has 24 stocks in portfolio but only held nine covered calls at the end of June. The past week, the VIX jumped again above the 15 level.

JEPI has a less concentrated defensive equity portfolio that employs a bottom-up fundamental stock selection. JEPI also considers financially material Environmental, Social and Governance (ESG) factors in investment analysis and investment decisions. JEPI counts on a slightly lower dividend income of 1 to 2% compared to DIVO (2 to 3%). The expected options premiums are higher for JEPI (5 to 8%) compared to DIVO (2 to 4%). JEPI uses the calls more systematically than DIVO and this allows them to pay out higher dividends while it limits at the same time a bit more the upside potential of the underlying portfolio. The current low VIX will result in lower premium income for JEPI.

On a sector level, JEPI is more exposed to the two sectors that are not in a long-term uptrend: Utilities and Real Estate.

Unlike JEPI and DIVO, ICAP uses leverage. We do not really understand why one would use leverage in what's basically a low beta strategy like covered call writing. The leverage will allow ICAP to participate more in the stock market's upside. But leverage makes things only worse when stocks fall. In down markets there might be no downside protection at all. Leverage leads to a higher beta, both on the upside and on the downside.

Since the inception of ICAP in 2021, ICAP has indeed, compared to DIVO and JEPI, a much higher beta, but also a higher volatility, a higher downside deviation and a higher maximum drawdown. Despite the fact that equity markets are performing well this year, this higher risk doesn't translate in higher returns.

Regarding returns, DIVO and JEPI perform better, with the former outperforming the latter. This is also the case in the complete period since the inception of JEPI in 2020.

Outlook for covered call ETFs

For the outlook for covered call ETFs we look at the level of the VIX and the trend of the equity markets. The best scenario for covered call ETFs is a high VIX and equity markets that are trending higher. This isn't always the case of course. A high VIX often accompanies falling equity markets and vice versa equity markets that are trending higher are often accompanied by a lower VIX (as was the case in the past few months).

The past week the VIX jumped higher and this higher volatility translates into higher option premiums and hence higher option income.

Equity markets remain in an uptrend.

The current environment is a good backdrop for covered call ETFs in my view.

DIVO is a long-term uptrend, while JEPI and ICAP are in "neutral" territory.

Conclusion

The outlook for covered call ETFs is constructive. VIX is high enough to get good option income and equity markets are in an uptrend. Our favourite covered call ETF remains DIVO. JEPI is a close second while we keep advising to avoid ICAP.

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