(Bloomberg) - Over the last two years, Wall Street has convinced cautious equity investors to send billions of dollars into exchange-traded funds that use options to goose yields.
A vocal chorus of analysts has been warning against this booming trade, to no avail. Assets in the derivatives-powered ETFs have quadrupled to $69 billion.
Now Bank of America Corp. is joining the ranks of skeptics, saying such products often fare worse than simpler alternatives. After crunching performance data, the US bank finds that a vanilla bet on dividend-focused ETFs probably serves most investors better.
“The value really isn’t there,” said BofA strategist Jared Woodard in an interview. “Investors who are looking for the highest total returns or just capital gains should probably look elsewhere.”
Sold by firms including JPMorgan Chase & Co. and Global X ETFs, the strategies — which own stocks and trade options on the side to raise extra money — have a been a minor craze since the 2022 bear market, when they massively outperformed equity indexes. Over half of the 75 covered call products tracked by Bloomberg have been launched in the last 16 months.
BofA’s warning echo other naysayers who note selling call options against stocks — “overwriting” in technical parlance — worked particularly well back in 2022, because the market was in free fall and bullish bets were seldom cashed in. In other environments, market machinations create drags on the ETFs that are harder to overcome.
Two of the most popular products, the JPMorgan Equity Premium Income ETF (ticker JEPI) and the Global X Nasdaq 100 Covered Call ETF (QYLD), illustrate the issue. In 2022 when stocks plunged, JEPI and QYLD beat the S&P 500 and Nasdaq 100 by about 15 and 13 percentage points respectively. But as the overall stock rally gained momentum in the past year, the S&P 500 has beaten JEPI by 14 percentage points, while the Nasdaq 100 has outperformed QYLD by 19 points.
To proponents, data like that is only half the story. People buying the ETFs are attracted to their payouts and are willing forego upside in exchange for a position they perceive as less risky.
“For many covered call investors, the goal is less about tactical outperformance and more about achieving a stated objective. In many cases, the key consideration is income,” said Rohan Reddy, director of research at Global X. “The sacrifice for generating higher income often comes in the form of giving up total returns.”
JPMorgan didn’t respond to a request for comment.
To demonstrate the potential drag, the BofA derivatives team tested a strategy that sells a one-month call option on the S&P 500 every day, and found it has lost money over 90% of the time this year and achieved an annualized loss of 24% this year, the most since at least 2008, when they began the study. The period, of course, is one in which stocks mostly appreciated, creating a difficult benchmark to beat while dulling profits for anyone who had sold bullish options.
The issue is both the rising market and chronically low premiums collected on bullish options due to the momentum of equity indexes over the past year, per Woodard.
“You’re getting hurt in two ways. You’re missing out on upside in the market, and you’re not being compensated the way that you historically would’ve done for selling those options.”
With the call overwriting being unprofitable in the past two years, simpler exposures to dividend stocks has provided superior returns. The First Trust Morningstar Dividend Leaders Index Fund outperformed a basket of option-income ETFs by 8% since 2018, the strategists found.
Complex options products also provide fewer tax advantages than high-dividend ETFs, according to BofA. For many options strategies, distributions may be taxed as income, and payouts from underlying holdings are not considered qualified dividends. For high-dividend funds like SPDR Portfolio S&P 500 High Dividend ETF (SPYD) payouts are taxed as qualified dividend income.
High-dividend funds could offer similar yields to option income ETFs on a tax-adjusted basis, the bank finds. Global X’s Reddy notes that some covered calls ETFs have some tax advantages as a big part of their distributions could be classified as return of capital.
Read more: Former AQR Quant Warns of ‘Grave Error’ Chasing Options Income
Investors who flocked to such products amid a five-month rally that boosted stocks by $10 trillion have underperformed underlying indexes. Their best hope now is for a more gradual rally or a slow selloff.
“Call overwriting will underperform when stocks are trading higher,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “It does appear the extreme rally from October to March has shown signs of closing so it could be a decent time for overwriting to make a comeback.”
Meanwhile, some financial advisers are steering clients to hide out in bonds, where yields are above 5% and investors won’t lose their principal.
“People are just saying, ‘Ok instead of 5.5% , I can get 7%’—but when things go down, that’s going to go down worse,” said Sam Huszczo, founder of SGH Wealth Management. “You’re still taking on way more risk than a traditional corporate bond getting 5.5%.”
By Emily Graffeo and Denitsa Tsekova
