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Covered Call ETF Flaws

This article is a guest post from Intelligent Speculator’s new site: Covered Call ETFs. The website covers everything you need to know about Covered Call ETFs.

There is no doubt that Covered Call ETFs have their flaws but the only reason why we would dedicate an entire niche website to the product is because we do see long term value in this product. That being said, all of the hype surrounding the most recent launch seem to ignore many of the basic characteristics of the product.

Here are some potential flaws that Covered Call ETFs have that investors need to consider:

There is no Free Lunch

Investing in these types of products can seem complex but it’s actually simple. Any product that promises extra returns or income has a downside. There is no alternative. In this case, the main downside is the limited gains when markets rise (especially if it happens quickly). I think this is a common misconception in all financial products. When investors buy a capital protected product, there is a price to be paid. It might be in terms of annual costs, limited upside, or other trade offs. One thing stands true though, there is no free lunch and covered call ETFs are no exception.

Increased Trading Costs

Not only do these funds need to re-balance as do all other index funds but they must also trade options and roll them every month. Execution costs occur in addition to other indirect costs (such as the bid-ask spread on those options).

Increased Management Costs

The fact is that these funds are more active than passive. The manager has a lot of decisions to make (which strikes to sell, when to close them out, etc) which means the cost to the investor will be higher (management fees).

Fiscal Impacts

If you are not buying Covered Call ETF’s in a tax-free account, you will be taxed not only on the regular dividends but a part of those dividends will also be capital gains and be taxed as such. Thus, despite keeping your position and not selling it, you will encounter capital gains taxes on these.

Transparency

One of the great benefits in ETF investing is that investors generally know how the fund operates, what it owns, etc. That is not the case for covered call ETFs. Why? For example, a Covered Call ETF on an index of 60 stocks may not be writing options on those 60 names. It could be 10, 20, 30 or more. That makes a significant difference over time and makes it difficult for investors to truly know what they are getting when purchasing these products.

All of that being said, I still believe that the product is a great fit for many investors, especially when you consider that we may be looking at a flat market for many years. In such context, Covered Call ETFs could turn out to be a great investment. Are Covered Call ETF’s perfect? Absolutely not. They have flaws like any other financial product and should be evaluated accordingly.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 2 comments… add one }
  • Jordan August 5, 2011, 12:55 pm

    Great post Frugal, thanks! I bought a little ZWB & HEX in my TFSA as I think they fit well with my overall strategy.

    Have you been adding to your dividend portfolio during these recent buying opportunities? Some of the yields are looking pretty attractive to me.

  • FT FrugalTrader August 5, 2011, 1:11 pm

    Hey Jordan! I’ve been adding to my index positions in the RESP and have a close eye on a few dividiend payers that I like. RY and CNR are looking attractive. What about you?

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