What Are Covered-Call ETFs?

A covered-call ETF is an exchange-traded fund that owns a basket of stocks and sells call options on some or all of those holdings. The fund collects a payment, called an option premium, each time it sells a call. That premium is a large part of the income the fund pays out to investors.

How a covered call works

A call option gives the buyer the right to purchase a stock at a set price (the strike price) before a set date. When the fund sells that option, it receives the premium up front. If the stock stays below the strike price, the fund keeps the premium and the shares. If the stock rises above it, the fund’s gain on those shares is capped at the strike price.

The trade-off

• More income today: option premiums can lift distributions well above a typical dividend yield.
• Less upside: in strong rising markets, the capped gains mean the fund often lags the stocks it holds.
• Downside is not removed: if the stocks fall, the fund still falls. The premium only cushions part of the decline.

Questions to ask before you invest

• What does the fund hold, and what share of the portfolio has calls written on it?
• How has its total return (price change plus distributions) compared with the underlying index over several years?
• What are the fees (management fee or MER)?
• How much of the distribution comes from dividends, option premiums, capital gains or return of capital?

Covered-call ETFs can be a useful tool for investors focused on cash flow, but a high distribution is not the same as a high return. Understand where the income comes from and what you give up for it.