At a time when the cost of living is rising and market volatility appears to be rising, too, investors may be looking for current income to bolster their portfolios. Current income can especially help investors at or near retirement to adapt to retired life. Of course, many of the funds and ETFs that offer income do so with some kind of trade off. Covered call ETFs are known to have capped performance to offer that income.
Not all covered call strategies do that, however. ProShares offers covered call ETFs that provide income without those severe, monthly caps. VettaFi recently asked the firm’s Director of Investment Strategy, Kieran Kirwan, to weigh in and explain how their daily covered call ETFs work.
See more: ProShares Leaders Q&A on Dividend Aristocrat Suite
VettaFi: How, exactly, do funds like the ProShares Nasdaq-100 High Income ETF (IQQQ) and the ProShares S&P 500 High Income ETF (ISPY) deliver income to investors?
Kirwan: ISPY and IQQQ are next generation covered call strategies. Covered call strategies typically have two components: They buy stocks and then sell call options on those stocks in an attempt to generate additional income. ISPY for example, owns the stocks of the S&P 500 and then sells an S&P 500 Index call option in exchange for a premium.
The strategies generate income in two ways: earning premiums from selling call options and owning stocks that pay regular dividends. ISPY and IQQQ make distributions each month that reflect the income generated from both sources, including dividend income and option premium.
VettaFi: Your site notes that the funds use daily call options, which are a recent innovation — how do they differ from previous tools?
Kirwan: Traditional covered call strategies use monthly expiring options that can generate attractive levels of income, but require investors to make a costly trade-off between high income potential and potential total returns.
ProShares High Income ETFs offer something different. They were the first ETFs to use a daily options strategy in an attempt to improve the trade-off between income and total returns. This innovative approach creates the opportunity for investors to both target high monthly income and participate in equity market performance over the long term, potentially capturing returns that traditional strategies sacrifice.
VettaFi: How does a daily options approach improve the tradeoff faced by traditional monthly expiring options strategy?
Kirwan: Covered call strategies typically limit appreciation potential by capping the gains of the underlying stocks at the strike price of the option sold. When the option expires, if the market price of the stock has risen above the option’s strike price (so it’s “in-the-money”), the seller of the call option owes a payment to the buyer. This payment is equal to the difference between the stock’s market price and the option’s strike price. Once asset appreciation beyond the strike price occurs, the strategy’s ability to appreciate is effectively capped by the payout.
For a monthly covered call strategy, this can be a significant drawback if the value of the stock goes above, and stays above, the strike price early in the month. The strategy could potentially be unable to participate in gains for days, or weeks, until the call option expires and a new call option is sold, resetting the cap.
A daily covered call strategy seeks to overcome this by selling call options each day — a move that resets the cap. This allows greater participation in the market’s upside, up to the strike price, each day that it occurs.
VettaFi: Is there a particular type of investor or advisor client you believe is best suited to these funds?
Kirwan: The strategies are designed for investors who need an immediate level of income and could benefit from the potential price appreciation of equity markets over time, while being comfortable with equity market volatility. In particular, a daily covered call strategy may be compelling for investors looking to avoid either stretching for yield, such as with concentrated bets in lower-quality stocks or certain sectors, or potentially sacrificing long-term total return, such as with a traditional monthly covered call strategy.
Originally published on ETF Trends
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