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Investors who pumped tens of billions of dollars into funds offering insulation from volatility suffered sharp losses during this week’s stock sell-off, highlighting the perils for retail traders seeking easy ways to ride out market uncertainty.
“Covered call” ETFs have boomed in popularity in recent years, with assets under management growing from about $18bn in early 2022 to roughly $80bn as of July, according to Morningstar data. Covered call strategies involve buying a basket of stocks while selling income-generating derivatives tied to the underlying assets.
Inflows have been driven by the prospect of equity-like price gains combined with bond-style income and low volatility. JPMorgan’s popular Equity Premium Income fund (JEPI), the largest actively managed ETF in the US, aims to provide “a significant portion of the returns associated with the S&P 500 index with less volatility”, according to the fund’s marketing material.
But when markets move quickly, the relatively small income generated by selling options is not enough to offset the decline in the underlying shares. Many funds have been simultaneously underperforming and suffering sharp swings.
CBOE’s S&P 500 Buywrite index, a benchmark for covered call strategies, dropped 2.8 per cent on Monday, only marginally better than the S&P 500’s 3 per cent fall. While the S&P is still up 9 per cent year to date, the Buywrite is up less than 4 per cent.
“These funds don’t like volatility,” said Ronald Lagnado, research director at Universa Investments, a fund that specialises in hedging against serious market downturns. “They call it an income strategy, but really you’re just selling volatility. That can work out for long periods but can get completely hammered when you have a severe crash.”
The potential defensive appeal of covered calls gained traction in 2022 as both equity and bond markets went into slow and steady declines. But Lagnado said that over the long term, their performance was little different from a classic 60/40 portfolio of stocks and Treasury bonds.
A JPMorgan Asset Management spokesperson acknowledged that “investors should not expect call-overwriting strategies to outperform the market on the upside over the long-term” while emphasising they could be useful for “pure income”, conservative equity exposure or replacing certain types of credit investments.
The company argued that “we have seen the more defensive nature of these strategies come to life” during the recent market turbulence. It said JEPI had outperformed the S&P 500 by about 2.5 per cent since the start of August. However, while the recent drops were less sharp in absolute terms, they were worse than the benchmark index when measured relative to year-to-date returns.
JEPI’s year-to-date return has fallen by 43 per cent since the start of August, more than the 40 per cent drop in the S&P’s returns, according to Bloomberg data. It has generated a total return of 4.9 per cent year to date, compared with 9.9 per cent for the S&P 500.
Popular funds tied to the tech-dominated Nasdaq 100 index have similarly underperformed. One-hundred dollars invested in Global X’s $8bn Nasdaq 100 Covered Call ETF at the start of 2024 would be worth $101.45 after Wednesday’s close, compared with $106.68 for an investment in the underlying index, according to Bloomberg data. The Global X fund has shed more than 80 per cent of its year-to-date returns since the start of August, compared with 57 per cent for the index.
“I always maintain that for a long-term investor, it’s not a buy-and-hold investment,” said Lan Anh Tran, a manager research analyst with Morningstar. “You’re giving up a lot of upside, and compounded over the long term, that’s not a good proposition.”
Robert Scrudato, an options research analyst at Global X, noted that the Global X Nasdaq 100 Covered Call ETF lost about 6.54 per cent from the end of July through August 5, while the underlying index lost about 7.58 per cent.
“In the grand scheme of such a drawdown, which took place over such a short period of time, this outperformance of over 100 bps might be considered significant to some,” Scrudato said.
Howard Chan, chief executive of Kurv Investment Management, said covered call strategies can be useful for investors such as retirees for whom income is particularly important. “The use is for a very particular segment of the market,” he said.
Kurv has recently launched several ETFs that try to overcome some of the drawbacks of the strategy by only selling options during certain market conditions instead of mechanically at regular intervals. But, he added, funds should be careful about how they describe themselves to make sure investors understand what they are buying.
“A statement can be [technically] correct but I think require a bit more explanation for retail investors . . . Once a fund gets popular, the original intent and segment which it serves can get lost and everyone piles in, including people who potentially don’t know what that fund is for.”
