2023-06-24 05:28:01 ET
Summary
- Covered call funds provide investors with strong yields.
- Almost all covered call funds have underperformed YTD, although margins do vary.
- An explanation as to why follows.
Covered call funds significantly outperformed their benchmarks in 2022 , and by very healthy margins.
Covered call fund relative performance has weakened, with most such funds underperforming their benchmarks YTD, although by smaller margins.
Owing to the popularity of these funds, thought a quick writeup looking at the reasons for their underperformance would be of use and interest to readers. Covered call funds have underperformed YTD as these have significantly reduced potential capital gains, which reduced gains when stocks soared earlier in the year, and because volatility has come down, leading to lower option prices and premiums.
The Nasdaq-100 has seen particularly strong gains this year, so covered call funds focusing on said index have underperformed the most.
Regional bank woes have caused significant losses across small-caps these past few months, leading to particularly weak performance for covered call funds focusing on the small-cap Russell 2000 index.
Insofar as current trends continue, covered call funds should continue to underperform. Current trends are for +30.0% annual gains on the S&P 500, which are not impossible , but are very optimistic, and long-term unsustainable. As such, and in my opinion, covered call funds remain reasonable investment opportunities, recent underperformance notwithstanding. Bullish investors, those expecting very strong gains for the rest of the year, might disagree.
I'll be focusing on the Global X NASDAQ 100 Covered Call ETF ( QYLD ) for the rest of the article, but everything here should apply to most other covered call funds too, to some extent at least.
QYLD - Quick Overview
QYLD's underperformance was due to how the fund's investment strategy functions under recent market conditions / performance. The strategy is remarkably simple: the fund invests in the underlying holdings of the Nasdaq-100 and sells covered calls on the entirety of its holdings. Strike prices are very slightly out of the money, and expiration dates are for one month after.
QYLD's investment strategy significantly reduces the fund's gains when the Nasdaq-100 increases, in exchange for a flat option premium received in cash. Downside potential remains unchanged. Profits are as follows, take special note to compare profits for the strategy versus profits for simply holding the stock.
QYLD partially distributes option premiums to shareholders, to a 1.0% monthly cap. Undistributed premiums are retained within the fund, and used to buy more shares in underlying Nasdaq-100 holdings.
QYLD's strategy massively increases the fund's yield, due to generating and distributing lots of option premiums.
QYLD's strategy also reduces potential capital gains and share price appreciation, due to selling covered calls.
With the above in mind, let's have a look at the fund's recent performance.
QYLD - Recent Performance Analysis
QYLD has significantly underperformed the Nasdaq-100 YTD.
The same is true for most of the larger covered call funds, including the JPMorgan Equity Premium Income ETF ( JEPI ):
the Global X S&P 500® Covered Call ETF ( XYLD ):
and the Global X Russell 2000 Covered Call ETF ( RYLD ):
Covered call funds have more or less all underperformed YTD, which means underperformance was due to commonalities in their strategies / market conditions. I've identified two issues.
First, is declining volatility. Higher volatility increases the chances options finish in the money, increasing their expected profits, and hence their demand and prices. Lots of investor demand for Nasdaq-100 call options when volatility is high and prices (and profits) could soar, less so when markets are muted, and potential profits are muted too. Equity volatility has declined YTD, as markets conditions settle from a tumultuous 2022. Small-cap volatility has declined the least, due to regional banking woes.
As equity volatility decreased during the year, so did option prices, leading to lower option premiums for covered call funds, resulting in lower distributions and returns for these funds. Lower volatility could lead to lower returns moving forward as well, contingent on, well, on volatility remaining low. Bear in mind, volatility does not look terribly low on a longer time-frame, so current values are mostly fine, if lower than in the recent past.
Second reason for covered call underperformance is strong equity capital gains, especially in January and June of this year.
Covered call funds see few gains from higher equity prices, equity prices rose a lot, so these funds underperformed.
Underperformance was greatest for Nasdaq-100 covered call funds, as tech stocks have seen the strongest gains YTD.
Underperformance was moderate for most S&P 500 covered call funds, considering equity market gains. By my calculations, QYLD was roughly matching the performance of the S&P 500 when said index was seeing annualized returns of 15.0% - 20.0%. Underperformance reached the single digits at annualized returns of +25.0%. Equity returns had to be very strong for the fund to underperform in any real material sense.
In my opinion, although QYLD has underperformed YTD, fund performance is indicative of a strong investment strategy and value proposition. I imagine lots of investors would be happy to receive lower returns during a bull market, if it meant moderately lower losses during a bear market, as has been the case for QYLD in the recent past. Although there is no guarantee that QYLD will continue to perform in this manner, the fund's performance is encouraging. On the other hand, fundamentals (volatility) have somewhat weakened, although these have not prevented QYLD from performing reasonably well YTD.
Underperformance was quite small for RYLD too, although the situation is somewhat complicated.
The Russell 2000 saw strong gains in January, during which RYLD underperformed, as expected.
From February to May the Russell 2000 was down. RYLD has outperformed since, due to the fund's strong distributions and some premium re-investing.
The net result of the above was for RYLD to underperform.
Covered call funds tend to underperform during very sharp market movements, as these funds experience few gains, but bear the full brunt of the losses. Small-caps have seen very sharp movements all year, with skyrocketing gains in January, and quick losses in March.
Although RYLD has underperformed YTD, the fund's overall performance remains reasonably good. As was the case for XYLD, RYLD outperformed in 2022, and by a much larger margin.
Sharp price movements like those experienced by small-caps these past few months are equivalent to higher volatility, which boosts option prices, leading to higher premiums for RYLD. Higher premiums boost fund returns, and the impact could prove to be quite significant, depending on the magnitude and duration of the increased volatility. In this particular case, the increase in volatility was not all that significant, and has since evaporated.
As an aside, and in the interest of full disclosure, I've been very bullish on RYLD for quite a while now, and the fund has significantly underperformed expectations in the recent past. Long-term performance remains adequate, although not terribly strong.
Conclusion
Covered call funds, including QYLD, have underperformed YTD due to strong equity gains and decreased volatility. Notwithstanding recent underperformance, the value proposition and investment thesis of these funds remain reasonably strong, in my opinion at least.
For further details see:
Why Have QYLD And Other Covered Call Funds Underperformed YTD?