The idea that covered calls generate

income is financial These

strategies are mechanically expected to

underperform their underlying equity and

increasingly so at higher targeted

levels of distributions. For long-term

investors, covered calls increase risk

by leaving the downside unprotected

while capping the upside, eliminating

the mean reverting behavior of stocks,

an important feature of stock returns.

I'm Ben Felix, chief investment officer

at PWL Capital, and I'm going to tell

you why the so-called passive income

from covered calls is a devil's bargain.

The preference for income is one of the

strongest behavioral biases in

investing. It can make people do silly

things in their search for income. Some

investors look for funds that pay high

distributions. This is well known by

fund managers who use high distribution

yields to attract investor dollars. The

problem for investors is that marketing

these yields in the case of covered

calls as income or even worse as

expected returns is financial

is not a lie to be clear. It is

indifference for the truth. Selling a

high distribution yield as an expected

return ignores the fact that yields on

covered call strategies are inversely

related to their expected returns.

Higher yields mechanically mean lower

expected total returns. Total returns,

to be clear, are what you need to buy

groceries. I'm going to walk through why

distribution yields are not returns, how

covered calls reduce expected returns,

and why I think the return profile of

covered calls makes them particularly

risky for long-term investors. To avoid

being too theoretical, I'm also going to

go through the performance of a bunch of

covered call funds to show that what I'm

saying is not just theoretical. It is

exactly what's happening in the live

funds. Let's start with some background.

Selling a call option on an equity that

you own generates income and creates a

liability that empirically more than

offsets the income received. This makes

the distribution yield uncovered call

funds a misleading metric. Selling a

call option means selling the right to

buy the underlying stock at a

predetermined price called the strike

price in exchange for a premium. An

equity covered call strategy invests in

stocks and sells call options on those

stocks. A fund using the strategy

typically distributes the derivative

income from selling calls as cash to

investors, resulting in their high

distribution yields. While those

distributions may feel like investment

returns, 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, who the fund

sold the option to, will exercise their

call option, and the fund will have to

sell the stock at a price below its

market value, putting a cap on upside

returns. Okay, I want to dig a little

deeper into the mechanics of what's

going on from the perspective of

expected returns. Call options are

positively exposed to their underlying

equity measured by a term called delta.

Buying a call option on a stock gives

you positive exposure to the price

movements of that stock. Selling a call

on an asset that you own, a covered

call, reduces your exposure to the

underlying stock. You're shorting

exposure to the underlying equity by

selling the call option. Holding option

maturity constant, call option prices

and deltas monotonically increase in a

decreasing strike price. If you want

higher income on your covered call

strategy, you can sell options with

lower strike prices resulting in higher

income and importantly higher short

delta. This is crucial in understanding

how yields are related to expected

returns. In simple terms, higher yield

mechanically means lower exposure to the

underlying asset by being short a higher

delta option and correspondingly it

means lower expected returns. When you

sell the call option, you receive an

option premium that feels like income

and is packaged up and distributed by

covered call funds as a cash

distribution. But the fund now has this

liability, the potential need to sell

the underlying shares below their market

value if the price rises above the

strike price. This liability exists

until the position is sold or the option

expires. Remember, the expected return

of the short call is increasingly

negative with an increasing derivative

yield. Here's why this matters. Over the

full life cycle of this type of trade,

the outcome is generally worse than

simply having held the underlying

equity. Part of the reason is a lower

equity beta, meaning less exposure to

the equity risk premium. To be clear,

this is something that you could do by

simply reducing your exposure to the

stock directly and holding some cash.

I'll come back to that with an example

later. The problem is that the reduction

in exposure to the equity risk premium

is also asymmetric. You keep most of the

downside while capping your upside at

the strike price. This means that

through any periods of market

volatility, which are of course common

in equities, in stocks, you eat most of

the downside, but you do not participate

in a large portion of the upside.

Systematically missing out on stock

market recoveries, which are common

after major downturns, can be very

expensive. Before I continue, I do need

to mention a potential saving grace for

covered calls. The volatility risk

premium. Equity options tend to be

priced with an implied volatility higher

than realized volatility. This creates

the opportunity for option sellers to

earn an expected risk premium for

enduring the risk of an extreme event

where realized volatility exceeds

implied volatility. While it makes back

tested cover call strategies look really

good in recent history since about 2011,

the volatility risk premium has not been

anywhere near sufficient to offset the

reduction in equity exposure from

selling the options resulting in poor

performance for these strategies. This

kind of thing can happen when a trade

becomes too crowded by, say, the

proliferation of retail funds chasing

the strategy. I want to make sure it's

really clear that the point about

asymmetry is particularly important for

long-term equity investors who have

historically benefited from a little bit

of mean reversion in stocks, making

stocks a little bit less risky at long

horizons than they would be if returns

were completely random. In simple terms,

after stocks have performed really

poorly, they tend to perform a bit

better than average. This is in contrast

to bonds which do not tend to have the

same rebound effect after poor

performance. In fact, bonds often

continue having poor performance after

having poor performance. Based on this,

some research has suggested that the

higher expected returns and mean

reverting tendencies of stocks make them

less risky than bonds for long-term

investors, including long-term investors

who need to live off of their

investments. But here's the problem.

Selling calls on your equity positions

both lowers the expected returns and

eliminates the mean-reverting tendency

of stocks by capping the upside return

while only slightly improving the

downside by the amount of the option

premium. Again, getting most of the

downside with a limit on upside is not

good. I would argue that it makes

covered calls very risky for long-term

investors who are concerned with funding

their inflationadjusted spending. This

might be hard to believe given the large

distribution yields of these strategies.

But it's important to remember that

these distributions are not income in

the way that say bond interest is and

presenting them this way is

irresponsible. The option premiums come

with an associated liability that lowers

expected returns and transforms the

shape of the distribution of returns

into something much less favorable for

long-term investors. One of the biggest

problems I see for these funds is that

their distribution yields are often much

higher than their total expected

returns. Yet, they're occasionally

discussed in income investing and fire

communities as if their distributions

are perpetually sustainable. It even

gives some people the idea that they

should borrow money at say 5% to invest

in cover called funds with a 14%

distribution yield. The combination of

high distribution yields, lower expected

returns, an uncapped downside, and a

capped upside means that someone who's

spending the distributions could deplete

their capital fairly quickly. This is

another reason why calling these

distributions passive income is

financial If you need a

psychological trick to help you spend

down your capital, covered calls might

be the answer, but their distribution

yields are not a sustainable source of

long-term income. I'll say it one more

time. Covered calls are not good for

long-term investors. Stocks have

positive expected returns and

mean-reverting tendencies. Covered calls

reduce exposure to the underlying stocks

and chop off the right tail of the

distribution of returns, capping the

ability of the underlying to recover

from downturns. This effect compounds

over time, driving an increasingly large

wedge between the performance of the

covered call strategies and their

underlying equities. This is true in any

market conditions. I often hear that

covered calls are great in a sideways

market, but equity markets don't go

sideways. They are volatile even over

periods where they have flat returns.

Every time your covered call strategy

eats downside and is denied upside, you

are losing. Okay, that's all fine in

theory. Let's look at some live funds.

There are quite a few covered call ETFs

with reasonably long histories to

examine. These can be compared to ETFs

investing in the underlying equities

without selling calls to see all of the

points I've made so far happening in

live products. I looked for covered call

ETFs with minimum 10-year histories.

Beimo has a few that launched in 2011.

The Beimo covered call utilities ETF

launched October 20th, 2011. It

currently has a distribution yield of

7.37%

compared to 3.43% for an ETF of the

underlying equities. In periods where

the underlying equities do not perform

well, the covered call fund has been

able to outperform, but these periods

have tended to be brief and in the long

run are far more than outweighed by the

capped upside. Over the full history

since inception, the covered call fund

has trailed the underlying by an

annualized 2.6 percentage points. and it

has trailed the underlying in more than

70% of three-year rolling periods with a

one-mon step. Increasing the rolling

window to four years results in the

covered call fund trailing nearly 85% of

the time. The underperformance is

particularly pronounced when the

underlying equities drop dramatically

and then recover, which is a pretty

typical characteristic of equity

returns. As I mentioned earlier, I also

mentioned earlier that reducing equity

beta by holding cash can get you to a

similar place as a covered call, at

least from the perspective of beta. I

ran a portfolio of 60% Beimo equal

weight utilities and 40% cash well high

interest savings account from October

2013 through August 25th 2025. You can

see they track pretty closely most of

the time except that the covered call

fund gives up extreme upside events and

eats the whole meal on the downside. I

won't keep repeating that equity plus

cash comparison, but Jeff Pac, managing

director for Morning Star Research

Services, recently showed in a sample of

22 single stock covered call ETFs that a

combination of cash and the underlying

stock outperformed most of the funds had

lower volatility than all of the funds

and had a higher sharp ratio than most

of the funds. Another Beimo fund with a

reasonably long history is the Beimo

Covered Call Can Canadian Banks fund. It

launched January 28th, 2011. It has a

current distribution yield of 6.13%

compared to 3.61% for an ETF of the

underlying equities. It has

underperformed by an annualized 2.71

percentage points since inception and it

has only outperformed in less than 1% of

rolling 3-year periods since inception.

The Global X S&P TSX 60 covered call ETF

launched on March 16th, 2011. It

currently has a distribution yield of

7.67%.

It has trailed the EyesShares S&P TSX 60

ETF by 3.65 percentage points since

inception and it has trailed in 92% of

three-year rolling periods since

inception. I can go on, but you get the

idea. Covered calls are not good for

long-term investors who expect positive

returns from the underlying assets. The

ones I have mentioned so far are pretty

tame with distribution yields in the 6

to 7% range. I think where these

products really go off the rails is when

they push for even higher yields.

Remember from earlier, if you want

higher income on your covered call

strategy, you can sell options with

lower strike prices, resulting in higher

income, and higher short delta. In other

words, targeting a higher income

exacerbates all of the issues I've

mentioned with covered calls. Lower

strike prices result in higher

distribution yields, less exposure to

the underlying equity, and a tighter cap

on upside performance. Hamilton ETF's

yield maximizer ETF series targets

yields well over 10% by selling at the

money call options. Take their US equity

yield maximizer ETF as an example. It

targets a distribution yield of 12% and

has underperformed an S&P 500 ETF by an

annualized 4.48 percentage points over

its admittedly short history. I also

want to mention JAPI. This is JP

Morgan's equity premium income ETF. It

gained a cult-like following around 2022

when it outperformed the S&P 500 by

nearly 15 percentage points. That

combined with its prominently marketed

high distribution yield has made it

extremely popular with retail investors

in general and income focused investors

in particular. It even has its own

subreddit. The problem is that like

other covered call strategies, it has

underperformed an S&P 500 ETF. In this

case, by 5.92 percentage points since

inception in May 2020. This one's not a

perfect comparison to the underlying

equity since JAPI's underlying equity

portfolio is actively managed. I don't

know if blaming the underperformance on

active management or uncovered calls is

worse, but in either case, we know these

things generally don't play out well for

investors in the long run. The most

recent and ridiculous development I've

seen in the covered call space is single

stock covered call ETFs. These are

exactly what they sound like, covered

calls on single stocks in an ETF rapper.

Some of their distribution yields are

astronomical, but as you might expect by

now, so is their underperformance. TSLY

writes covered calls on Tesla shares.

Its distribution rate at the time of

writing is 48.59%.

But since inception in November 22, it

has underperformed Tesla by more than 20

percentage points annualized. These

numbers are ridiculous, but they

certainly do highlight the previously

mentioned relationship between high

derivative income yields and low

expected returns. The last point worth

mentioning is that covered call funds

will tend to have higher fees and

transaction costs than funds holding

their underlying equities. For the

sample of funds that I mentioned in this

video, excluding the single stock fund,

the average management expense ratio is

0.63%. 63% and the average trading

expense ratio is 0.16%.

While funds holding the same underlying

equities have an average management

expense ratio of 0.25% and an average

trading expense ratio of 0%. You are

paying a significant premium to access

all of the downsides of covered calls.

Those high income distributions have to

be really really psychologically

important to you for all of this to make

sense. For completeness, I do want to

say that some investment managers may

successfully use covered calls to access

the volatility risk premium, but this is

a fairly esoteric risk premium that is

probably not required for the typical

household saving for or living in

retirement. Even if there is a

volatility risk premium worth pursuing,

covered call funds are typically

marketed to retail investors based on

their distribution yields, not their

exposure to the volatility risk premium.

In my opinion, selling these products on

their yield, which in the case of

covered calls is inversely related to

their expected returns shows

indifference to the truth. It is bullit,

especially when it's held up next to

things like treasury bill yields. Taken

together, covered calls don't have

anything special to offer. They get you

to a place similar to holding a bunch of

cash, except that your upside is limited

and your downside is unlimited. They're

more likely to be detrimental to most

investors expected outcomes than to

improve them. Their high yields come at

the expense of lower expected returns

and historically lower realized returns.

The volatility risk premium, which could

theoretically help covered calls recoup

their lower expected returns, has not

been anywhere near sufficient to offset

the reduction in expected returns since

around 2011. All of these downsides show

up very clearly in the terrible

long-term performance of live covered

call strategies when measured properly

by their total returns. Thanks for

watching. I'm Ben Felix, chief

investment officer at PWL Capital. If

you enjoyed this video, please share it

with someone who thinks the 14%

distribution yield undercovered call

fund is an expected return.