On a recent Motley Fool Money episode, analyst Lou didn’t dress it up. “A lot of products on Wall Street were built to be sold, were built for the fees, not necessarily built because they really, really work for the buyer,” he said. He was talking about the covered-call income ETF boom, and specifically the funds retirees are being pitched as bond substitutes.
If you own Neos S&P 500 High Income ETF (BATS:SPYI) or NEOS Nasdaq-100 High Income ETF (NASDAQ:QQQI), or your advisor keeps mentioning them, the numbers deserve a hard look.
The verdict on covered-call income funds
Lou’s colleague Matt gave the fairer version. Retirees, he said, “want current income without having to sell the stocks that they own,” and covered-call funds scratch that itch. SPYI has pulled in roughly $6.9 billion in assets doing exactly that, paying out monthly distributions around $0.51 to $0.53 per share on a stock trading near $53. Money hits your account every month. Psychologically, that feels like a paycheck.
The verdict, though, is that this is a supplement to an income plan. The mechanic is simple. The manager owns the underlying stocks and sells call options against them. You get the premium as income. In exchange, you cap your upside. When the market rips, you get left behind. When the market crashes, you eat almost the full loss because the option premium you collected is a rounding error against a 20% drawdown. Matt put the ceiling plainly. A sharp S&P 500 decline would “more than offset any options premium they’re collecting.”
What the fees actually cost you
Here is where the “built to be sold” charge lands. SPYI charges an expense ratio of 0.68%. QQQI charges 0.98%. The passive benchmark, SPDR S&P 500 ETF (NYSEARCA:SPY), charges about 0.09%. You are paying roughly seven times as much for SPYI and roughly ten times as much for QQQI, and the underlying holdings are the same mega-cap names. QQQI’s top positions include the same mega caps at similar concentrations to the QQQ but with a different price tag.
Now look at the trailing year. SPY returned about 21% over the past twelve months. SPYI returned about 19%. QQQI, riding a stronger Nasdaq, returned about 26%. That is, of course, if you reinvest the dividends. Taking the dividends is the whole point of investing in these covered-call ETFs, and when you do that, the returns drop to 5-8%.
The gap looks small in a good year. That is exactly the problem. Wes Moss, on the Clark Howard show, ran the longer version of this trade. Over five years, he said, “let’s say the market’s over the last five years up 90%, your covered call ETF may be up 50 or 60%. That’s counting the income that’s, that’s counting the option premium that you’re receiving.” Compound that gap across a retirement, and the income felt great while the nest egg shrank in relative terms.
The tax bite nobody advertises
The other quiet cost is the IRS. Distributions from option premiums are generally taxed as ordinary income, not qualified dividends. If you are in a 24% or 32% federal bracket and holding SPYI in a taxable account, a chunk of that headline yield walks out the door in April. Qualified dividends from SPY, by contrast, top out at 20% for most retirees and often less. The advertised yield and the yield you keep are different numbers.
However, there’s one condition where these funds shine.
Matt was specific about the environment. Covered-call funds work best when the market grinds up slowly, at something like 5% a year. In that world, calls expire worthless, you keep the premium, and you also keep most of the modest price appreciation. In a bull rip, you cap out. In a bear, you get shredded with a small band-aid on top.
What to actually do
- Size the position with restraint. If you want a covered-call ETF in your income bucket, treat it as a slice of the portfolio. A tenth of the portfolio is a different conversation than a third.
- Hold it in an IRA if you can. Ordinary-income distributions are far less painful when they’re not taxed annually.
- Compare total return over multiple years. Pull up SPYI against SPY on any charting site and look at total return, dividends reinvested, over three and five years. That is the number that matters.
- Consider doing it yourself. As Matt noted, you can own SPY and sell your own covered calls, keeping the premium and skipping the 0.68% management layer.
The monthly deposit is real. So is the fee. Decide which one you are actually buying.
Contact [email protected] for any questions or corrections.
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