I was not going to make another video on

covered calls, but I was at a retail

investor conference recently. That's me

and the plain bagel up on stage and I

spent the day talking to retail

investors. It struck me how hard the

conference attendees were being sold on

covered call funds and how frequently I

was being asked about them. When I made

my last video on this topic, I honestly

did not realize how widespread this

financial had become. These

products are likely to be detrimental to

long-term investors, including those who

need income. And I think it's important

for the truth about what they should be

expected to do to be articulated in an

understandable way. I'm Ben Felix, chief

investment officer at PWL Capital, and

I'm going to tell you again why the

passive income from covered calls is a

financial

I'm going to start with some quick

background uncovered calls, go through

some live fund examples with reasonably

long-term data, including dividend

reinvestment, and then go through

similar examples modeling spending from

the portfolios. As you will see, even in

that case, covered calls perform worse

than their underlying equities. If you

stick around to the end of the video, I

also have some comments on whether I, as

a chief investment officer and portfolio

manager, am professionally threatened by

covered calls and also why people need

to be aware of incentives when they are

consuming information. Covered calls are

a perfect storm of financial innovation,

which tends to favor the financial

product provider more than the end

consumer, and investor biases, which

lead people to seek income producing

investments without realizing the cost

to total returns. Selling a call option

means selling someone the right to buy a

stock from you at a predetermined price

called the strike price in exchange for

a premium. Say the stock is trading at

$100. You sell a call option with a

strike price of $15 and you collect a $2

premium. The effect of this trade will

depend on the future price of the stock.

If the stock stays below $105, the

option expires worthless. you keep the

$2 premium, which means in this whole

light green shaded range in the chart,

you're always doing a little bit better

than if you had just held the stock. As

long as the stock stays above $98,

you're not losing any money on the

trade. If the stock rises above $15, the

option gets exercised. Your upside is

capped. You do make $5 from the stock

price increase plus the $2 premium from

selling the option. That's a maximum

profit of $7 on the trade. If the price

goes higher than that, you don't

participate in the upside. The line on

the payoff diagram flattens right there.

Compared to simply holding the stock,

you're ahead as long as the price stays

below $17. That's the strike price plus

the premium. But once it climbs past

$17, you would have been better off

without the covered call. And on the

downside, say the stock crashes to $50,

you still pocket the $2 premium, but

you're taking nearly the full hit on the

price decline of the shares. The premium

softens the blow a little tiny bit on

the downside, but your downside risk is

mostly unchanged from simply owning the

stock. A fund using the strategy

typically distributes the option

premiums from selling calls to

investors, resulting in their high

distribution yields. Those distribution

yields are misleading due to their

effect on total returns. Remember,

selling the call is only the first step

in the trade. The fund has sold the

right to buy the underlying stock at the

strike price. If the price of the

underlying rises above the strike price,

the option holder, whoever the fund sold

the option to, will exercise their call

option and the fund will have to sell

their stock at a price below its market

value, putting a cap on upside returns.

The result is that selling the call has

reduced exposure to the underlying

equity primarily on the upside while

downside returns remained largely

exposed, reducing expected returns and

capping the ability of the fund to

recover after the inevitable downturns

that stocks experience. For long-term

investors, my view is that covered call

funds are not good investments. They do

not generate passive income and they

create unnecessary layers of risk and

cost. This is also true for investors

who need income as I will show you with

five examples in just a minute. These

funds create the illusion of income

while systematically lowering expected

returns and increasing risk by changing

the shape of the distribution of

returns. One of the most common

questions that I got on my last video

was whether my performance comparisons

assumed the reinvestment of

distributions. The yields on these

covered call funds are incredibly high.

So distributions being reinvested or not

does matter a lot. I can confirm that my

performance comparisons did assume

reinvestment of distributions and they

will in this video too. Let's look at

some quick examples. The Global X S&P

500 covered call ETF has trailed the

EyesShares Core S&P 500 ETF by an

annualized 3.15 percentage points since

January 2014. The Global X S&P TSX 60

covered call ETF has trailed the

Eyesshares S&P TSX60 ETF by 3.81

percentage points since March 2011. and

the BIMO covered call Canadian banks ETF

has trailed the BEIMO equal weight banks

ETF by an annualized 2.86 percentage

points since February 2011. An important

question is whether total returns which

we just looked at are the right metric

for an income oriented investor. The

premise here is that showing wealth

accumulation and annualized returns, as

I just did, might itself be misleading

if covered calls actually perform better

in a scenario where funds from the

portfolio are needed each month to buy

your groceries and pay your property

taxes or rent or whatever. I'm going to

address this with a simple portfolio

withdrawal analysis. I have 10 years of

data for five pairs of funds. Each pair

has a covered call fund and a fund of

the underlying equity or a very close

proxy for the underlying equity. In my

model, the investor in the covered call

fund is spending approximately the

fund's distributions while the investor

in the underlying equities will spend

the same dollar amount as the covered

call investor each month through a

combination of portfolio dividends and

selling shares. I'll say it again since

this is really important to the example.

They are both spending the exact same

dollar amount each month. But the

investor in the regular equity fund in

the underlying equities is creating

their own income through a combination

of dividends and sales from the

portfolio. Believe it or not, whether

your returns come from income or

capital, it is the combination of the

two, the total return that actually

matters for funding your consumption.

And it is possible, contrary to popular

belief, to spend from the capital

portion of a portfolio sustainably. If

you do not believe this to be true, you

are suffering from the mental accounting

bias and it may be costing you a lot as

we are about to see. This withdrawal

analysis will give us ending portfolio

values to compare where a higher

portfolio value, remember holding

withdrawal amounts constant in dollar

terms suggests a better outcome. After

running through the withdrawal

scenarios, I found that not one of the

covered call funds had higher ending

wealth after 10 years than a comparable

fund of the underlying equities. The

investor in the underlying spent the

same dollar amount as the covered call

investor each month and had on average

26% more capital left after 10 years.

Mind-blowing passive investment income

in shambles. I was not surprised by this

and you should not be either. Covered

calls are capping upside returns without

offering downside protection and their

yield is far from sufficient to offset

the lost upside. The implied cost of

these products is substantial. I solved

for the non- taxdeductible fee that you

would have to pay to invest in the

underlying equity funds such that the

ending wealth outcomes are equal to

their covered call counterparts. The

break even fee was between 1.5 and 2.7%

depending on the fund. That's not to

suggest that you should be paying a fee

that high to invest. It just illustrates

how much the covered call strategy is

costing you relative to simply investing

in the underlying equities and creating

your own income stream by receiving

dividends and selling some shares. The

other thing I looked at is how much cash

you would need to hold alongside the

underlying equities in each case such

that the ending wealth for the covered

calls fund and the portfolio of the

underlying equities plus cash have the

same ending wealth. Again, holding

withdrawals constant. Remember that

covered calls reduce your exposure to

the underlying equities asymmetrically

by capping upside while leaving downside

mostly exposed. Another way to reduce

your exposure to an equity is to

explicitly reduce your exposure to it by

selling some of your position and then

holding the sale proceeds in a low-risk

investment like a high interest savings

account. I found that the cash

allocation, the high interest savings

account allocation that make the wealth

outcomes equal range from 19% to 36%.

This means that in the most extreme case

in my examples, you could hold a

portfolio of 36% cash and 64% stock and

holding monthly spending constant at the

yield of the covered call fund have an

outcome equal to writing covered calls

on the same underlying equities. Again,

I am not suggesting that you should be

holding high cash allocations if you're

living off your portfolio, but I think

this is another great way to illustrate

the effect that cover calls have on

expected returns, including in cases

where the portfolio is funding cash flow

needs. It's similar to holding a whole

bunch of cash, except in the case of

covered calls, you're fully exposed to

the downside risk of the stock. At least

holding cash reduces downside risk

exposure. Again, this should not be

surprising. If you want income, creating

it yourself through a combination of

dividends and sales produces a better

expected outcome than writing covered

calls. Their high distribution yields

create the illusion of income. But that

income comes with a liability. The

capped upside on returns in the event

that the option is exercised. That at

least in these examples far more than

offsets the income. The other big

trade-off for long-term investors is

that by capping upside returns, you are

removing the mean reversion that

historical stock returns have exhibited.

After bad returns, stock returns tends

to bounce back. Those bouncebacks are

important to long-term returns and make

stocks a bit less risky than they would

be if returns were completely random. To

broaden my sample, I collected data for

20 Canadian listed covered call ETFs

with closely or identically matched ETFs

of the underlying holdings and I

compared their performance. To be clear,

we are back to total return comparisons

now, not withdrawal analysis, just

because it's a short time series of

data. In cases where the covered call

fund is not an index fund, I found a

fund with a high holdings overlap and

high return correlation to compare it to

for the underlying. I excluded really

niche funds and those without any

obvious comparables for the underlying.

This speaks to another problem that I

see with a lot of these products.

They're often really, really niche

sector funds and they often hold

concentrated, actively managed

underlying portfolios. Those sector bets

and the individual stock risk and the

active management all add to the risk of

these products for long-term investors.

I limited my sample to funds with at

least one year of history. I know that's

still way too short to draw conclusions

from, but this is what I had to work

with. There's just not a lot of funds

with really long histories. And the

newer funds tell the exact same story as

the older ones. Out of the 20 funds,

only two have outperformed a comparable

underlying equity fund. Both of them

were technology covered call funds with

fairly short histories and imperfectly

matched underlying equity portfolios.

So, I wouldn't read too much into those

two that under outperformed. On average,

the covered call funds in this sample

underperform comparable underlying

equity funds by an annualized 3.25

percentage points and the median

underperformance is 2.96 percentage

points. As we saw earlier, this

underperformance matters for both

accumulators and people drawing from

their portfolios. The last point I'll

cover is what are generally called

enhanced covered call funds. These funds

not only employ a covered call strategy,

but also use leverage to increase their

yield and their expected returns. I'll

be honest, these things are fascinating

pieces of financial technology. The

problem though is that the history of

financial innovation has tended to

create profits for financial product

manufacturers at the expense of end

investors. That aside, I think you have

to appreciate how incredible it is that

a fairly complex portfolio like this is

available under a single ticker. For

better or for worse, let's look at some

enhanced covered call funds. To keep it

simple, I will look at the Global X

index series of funds. Since they have

ETFs for the underlying, the underlying

with covered calls and enhanced versions

for both, they are targeting a leverage

ratio of 125% in their enhanced funds.

Across five index funds, all over

periods where returns have been overall

positive for the underlying equities,

the performance of the enhanced covered

call fund is above the regular covered

call funds and below the returns of the

underlying equities. The leverage

covered call funds have also performed

worse than the others during periods of

negative returns. What we'll generally

see is that leverage boosts returns of

these portfolios when times are good and

makes their draw downs more severe when

times are bad. No surprises there.

Overall though, leverage has helped all

of these enhanced funds outperform their

notenhanced covered call counterparts

over this short period, which should be

expected again when returns are

positive. Leverage is not a bad thing,

but I find the case for applying

leverage to a covered call fund to be a

little bit odd. Remember, covered calls

are capping upside and not helping much

on the downside. Leverage is enhancing

both the upside and the downside. If

you're comfortable with higher

volatility and leverage, leveraging the

underlying equity without writing calls

likely makes more sense. The data

support this. In all five of my example

funds, the leveraged version of the

underlying has outperformed the

underlying, the covered call fund, and

the leveraged cover call fund. One last

thing I want to address is whether I, as

a financial professional, feel

threatened by covered call funds, which

is something that has come up a few

times since I made my last video. The

idea seems to be that these products are

so good that they will put wealth

management firms out of business

entirely. They won't. Wealth management

is about much more than creating an

income stream in retirement. Expert

financial advice can be categorized into

areas where knowledge of base rates,

technical competence in financial

planning, and an understanding of human

psychology can be applied to help people

arrive at highquality financial

decisions. Those areas are goal

formation and quantification, asset

allocation, cash flow planning,

insurance needs analysis, financial

product allocation, and tax awareness.

Covered calls may kind of sort of solve

cash flow planning, but that's about it.

I also have some comments on where the

information promoting covered calls is

coming from. It is a requirement in

Canada for content creators to disclose

when their content is sponsored. This is

intended to avoid hidden conflicts of

interest. A lot of the content out there

promoting covered calls as a strategy

is, drum roll, sponsored by companies

selling covered call ETFs. This is

obviously a conflict of interest. At

least it isn't hidden, but it still

warrants caution. I have my own

conflicts of interest to be clear. I

work for PWL Capital which is a wealth

management firm. It is good for us if

people decide to delegate their

portfolio management and the financial

planning that informs that portfolio

management to us. But we have nothing to

gain or lose based on whether you invest

in covered call funds. As discretionary

portfolio managers, we can and as

fiduciaries, we must use covered call

ETFs in our clients portfolios if we

believe that is what is in the client's

best interest. We do not use them

because we think they are detrimental to

investors at any stage in life for the

reasons I have shown in this video and

in my last video. Other than the

psychological pacification that may come

from income distributions, these funds,

in my opinion, do not have any redeeming

qualities. I urge any investors who've

been wooed by the promise of so-called

passive income to ensure that they

understand exactly what they're

investing in and why those specific

investment characteristics are worth the

high implied costs I have detailed in

this video. I also implore you to

understand where you are getting your

information and what the information

sources incentives are. Thanks for

watching. I'm Ben Felix, chief

investment officer at PWL Capital. If

you enjoyed this video, please share

with someone who is not yet aware of the

high implied costs of covered calls.