XYLD - RYLD: Traditional Strategies Outperform Covered Call Complexity

Summary

• Global X Russell 2000 Covered Call ETF implements a Covered-Call "Income" Strategy over the Russell 2000. The fund structure extracts expensive fees and high trading costs in return for the promise of monthly dividend income.
• This dividend income presents itself as forced withdrawals. The result of covered-call strategies' forced withdrawal rate is lower long-term results than the underlying equity portfolio equivalents.
• With higher income and higher costs comes underperformance relative to traditional stock and bond approaches.
• My view is straightforward: traditional strategies accomplish covered calls' objectives more effectively, lowering the fund's rating to a Sell.

Income-oriented retail investors often prefer complicated, high-cost, high-yield approaches over a traditional return or risk-optimized stock/bond portfolio. The allure of a high dividend is obvious. It puts the money directly in your hand without selling shares directly yourself. The perceived results are higher-income, lower volatility, and greater peace of mind. Unfortunately, investors may not understand how covered call funds work from a big-picture view. As Nassim Nicholas Taleb stated in a 2015 conference , "If I don't understand something, exclude it."

I believe many RYLD investors are chasing a mirage of "free money" with hidden performance drag. RYLD exposes them to inflationary risks as stock returns may lose to inflation on a real basis. Worse, the underlying portfolio's methodology seems suboptimal. I find this leads to reduced returns, less safety, and more uncertainty than traditional equity and bond investments. As a result, combining stocks and bonds enables more efficient allocations than covered-call exchange-traded funds ("ETFs"), leading me to assign my rating of a Sell.

RYLD's Strategy and Portfolio

The Global X Russell 2000 Covered Call ETF ( RYLD ) implements a Covered-Call "Income" Strategy over the Russell 2000 Index ( RTY ). The fund uses the Vanguard Russell 2000 ETF ( VTWO ) for the underlying individual stocks. Then it sells covered calls 1 month out at the money. Finally, the resulting gains from individual covered calls are paid out to investors.

This caps upside returns in return for the perceived magic of "free money" 13.2% dividends. At the same time, investors are left out in the cold to experience highly market-correlated returns to the downside . They pay a 0.60% expense ratio for the privilege.

In this analysis, I will compare RYLD to its competitor with underlying stocks of the S&P 500 Index ( SP500 ), the Global X S&P 500 Covered Call ETF ( XYLD ). I will simultaneously compare to their underlying Vanguard equity ETF equivalents: the Vanguard Russell 2000 ETF ( VTWO ) and the Vanguard S&P 500 ETF ( VOO ), respectively. Afterward, I will compare the income results of these approaches to their competitor, the Global X Nasdaq 100 Covered Call ETF ( QYLD ), and return-optimized strategies of the Alpha Architect U.S. Quantitative Momentum ETF ( QMOM ) and Alpha Architect U.S. Quantitative Value ETF ( QVAL ).

The top 10 holdings, listed below with their weights, represent a mere 2.72% of total asset value. No holdings weigh more than 0.30%. The result is a portfolio of extreme diversification amongst individual holdings.

*As of 2023-02-27, compiled by Author using data from the fund website .

I would argue that there is even " diworsification " present in the construction of VTWO. Almost two thousand stocks are present. Without concentrating on stocks with higher expected returns based on factors, as discussed in my first Seeking Alpha article , investors may be missing out on a more optimal portfolio from an expected returns perspective.

Not only is the portfolio possibly "diworsified," but the Russell 2000 may be rebalancing too frequently .

Below is a sector breakdown from Vanguard of the underlying, VTWO, relative to the index, RTY. There are very slight differences between the two, with the largest difference being a 0.7% overweighting of consumer discretionary stocks.

Performance Cut By Complexity

The past one-year performance of RYLD has been substantially lower than both its underlying Russell 2000 ETF, VTWO, and the S&P 500 Covered Call fund, XYLD. Worse yet, its -1.24% tracking error relative to VTWO over the past year was not great either. Although, XYLD outperformed relative to VOO, and its 0.77% tracking error was certainly better. That said, it is a bad idea to base decisions on any individual year alone. Let's expand the back-test further.

The chart below casts a very different story, with VOO and VTWO each significantly outperforming the covered call equivalents . The tracking error has also expanded massively, with RYLD's tracking error a rough -7.01% since its 2019 inception and XYLD suffering an absolutely dreadful -27.53% tracking error. I believe many investors would be hard-pressed to sustain their investments amidst such a bout of underperformance.

Time to compare the covered call funds' income-prioritization performance to return-optimized strategies below.

Total Return Outdoes Covered Calls Long-Term

Below, I compare the Covered Call ETFs to Alpha Architect's deep value and momentum funds, QVAL and QMOM, each optimized with the goal of maximizing total returns over the long run using factor-optimization approaches. Until the last month, their expense ratios were 0.49% (now 0.39%), quite close to the 0.60% of the Covered Call ETFs. Even with that high expense ratio, the Alpha Architect funds achieved much higher total returns than their Global X Covered Call counterparts.

Covered-Call advocates argue from the view of an income-first approach, making the total-return focus seem mute. In their 1961 paper, “Dividend Policy, Growth, and the Valuation of Shares,” Merton Miller and Franco Modigliani show how shareholder results do not significantly improve when the dividend is provided to the shareholder today rather than reinvested later.

Regardless, a fund owner can create their own dividend by simply selling shares (and/or fractional shares) as necessary. This presents potential tax and total return benefits as the investor can take dividends they require instead of potentially paying taxes on excessive pay-outs they do not. Different countries and states/provinces will have different laws governing the taxation of these dividends. As always, readers should do due diligence to determine how much this taxation plays a role in their investment returns.

Thus, even though yields on the covered call ETFs are all hovering around the 12 to 13% mark (with roughly a maximum 1%/month distribution), we can simulate a 12% withdrawal from all funds in Portfolio Visualizer by stating a 1% withdrawal a month with excess dividends reinvested.

Note: Drawdowns in parentheses include 1% monthly withdrawals in calculations, effectively providing a money-weighted drawdown.

Compiled by Author using data from Portfolio Visualizer.

Higher returns bring higher perpetual withdrawal rates, and, ultimately, higher income. Despite the short dataset, the total return optimized strategies still provided higher income at the ending month than the covered call strategies.

Unlike the market-beating QMOM, covered call strategies that paid out the most in prior years paid out the least come January 2023, and vice versa.

And yet, higher returning strategies came with higher volatility and drawdowns. Investors often require a more balanced risk budget to stick with the plan. That's where bonds come in.

Bonds Outdo Covered Calls' Risk Control

Bonds allow an investor to lower portfolio volatility to a similar level as covered call funds while maintaining higher returns overall. Well, at least higher returns than they would achieve by employing an expensive covered call strategy.

QVAL is excluded from the comparison below as Momentum historically experienced lower volatility than Value, resulting in better risk-adjusted returns. Vanguard Intermediate-Term Treasury ETF ( VGIT ) is used for the bond portion of the portfolio. Investors may wish to choose other funds that closer match bond duration to their expected investment horizon.

Note: Drawdowns in parentheses include 1% monthly withdrawals in calculations, effectively providing a money-weighted drawdown.

Compiled by Author using data from Portfolio Visualizer.

Investors do not have to significantly rebalance to achieve the results above, as I tested this with rebalancing done passively via the monthly withdrawals themselves. In addition, an investor may prefer the ease of withdrawing annually. Historically, doing so realized very similar results to the above.

With that covered, it's important to address some common counterclaims that may come up in the comment section.

Addressing Counterclaims: Risks Vs. Results

The specific alternatives I described would also have highly different returns from typical stock market/bond market funds. If one regularly compares to S&P 500 or a standard 60/40, they could experience long periods of relative underperformance, and, ultimately, capitulation.

Unfortunately, I believe covered call strategies lead to long-term underperformance by design. This underperformance can be even worse because of the capped upside. In fact, RYLD performed with the highest volatility and deepest drawdown for similar results to its peers. An ugly duckling, even among covered call strategies. I attribute this to its poor portfolio construction methodology.

At the same time, there is an argument to be made that RYLD provides lower risk than equity equivalents. I prove this is not true relative to a balanced stock/bond combined portfolio. Ultimately, bonds can provide similar or better protection than covered-call funds while maintaining the upside potential.

One might argue that they would just perform an options strategy independently, cutting out the ETF middle-man. This is laden with psychological risks as retail option trading behavior has proven to be wealth-destroying . Worse yet, it was found to lack profitability on average . I believe even professional options traders may not wish to wager their own hard-earned capital in options trading due to everything that can go wrong.

While maximizing the downside and upside swings with alternative approaches can be hard, the reward is significant. Total return strategies overcome their initially slightly lower income amounts and ultimately exceed their covered call counterparts. A total return strategy combined with some treasuries may achieve higher returns at lower volatility than both the covered call strategy and its underlying.

Takeaway

While covered call funds like Global X Russell 2000 Covered Call ETF look attractive based on their yields, prospective investors can expect better and lower-cost results elsewhere. The simplest way is to simulate these candidates through a withdrawal strategy of their underlying stock portfolios for better results. Due to how inefficient those underlying strategies are, investors may prefer a combination of more traditional total return optimization with a risk budget. Outside of highly investor-specific behavioral and tax-optimization situations, I would steer investors away from covered call approaches altogether.

My view is straightforward: traditional strategies accomplish covered calls funds' objectives more effectively, lowering Global X Russell 2000 Covered Call ETF's rating to a Sell.

For further details see: