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Covered-call exchange-traded funds have proliferated in the Canadian market over the past few years. Their attractive yields have lured in billions in assets. From around 50 funds and less than C$10 billion under management in 2019, covered-call ETFs have grown to nearly 200 funds holding over C$30 billion as of February 2025.
A covered call isn’t a new strategy, and it certainly isn’t for everyone. The asymmetrical risk/return profile on these ETFs can hurt investors during large market moves, and many have underperformed the broader market over the long run. Evaluating only their yields understates their impact on a portfolio’s total return and total cash flow. This article breaks down the source of returns for these funds to give a clearer picture of their benefits and drawbacks.
What Is a Covered-Call ETF?
Their investment process is relatively straightforward: Buy stocks and sell calls on them. The premiums from selling calls make up most of covered-call ETFs’ yields. Such a fund’s payoff profile is asymmetrical by design. Imagine a hypothetical fund that writes monthly calls on the S&P/TSX Composite Index at a strike price slightly above the index’s current price, earning monthly call premiums. When the index declines, the equity portion of the fund falls with it. When the index rises, the call option loses money past the strike price, which caps the upside for the fund. Most covered-call funds sell calls at or slightly out of the money, foregoing considerable upside on the underlying index.
Payoff diagram of a covered call strategy
Source: Analyst calculation. Data as of 02/28/2025. Hypothetical example for illustrative purposes.
This upside cap is a tradeoff for the call premiums, which provide an incremental buffer against down markets. The premium correlates to implied volatility on the underlying index, which represents the market’s expectation of future volatility. The higher the implied volatility, the higher the call premiums, and vice versa. Volatility tends to rise in extreme market downturns, which increases call premiums and helps alleviate losses.
Still, this is hardly the ideal payoff profile: capped upside with a limited buffer on the downside. Covered-call ETFs work best in flat or sideways markets but disappoint otherwise. Call premiums will often trail stock gains during strong market rallies. Yet during major downturns, the ETFs still face significant tail risk, albeit cushioned to some extent with the premiums.
These ETFs’ market sensitivity and standard deviation of returns fail to reflect their skewed tail risk. Selling options effectively shorts volatility, making the fund appear less risky than the market despite similar exposure to a significant drop. Likewise, robust yields distract from the opportunity cost of foregone upside exposure.
No Risk, No Returns
Selling calls essentially sells insurance against upside volatility. Eyecatching premiums from covered-call ETFs are simply compensation for taking on volatility risk. Like other kinds of insurance, those who sell calls lose money if a specified event happens, like breaching the strike price. They require a premium for taking on this risk, which can be observed through the gap between a security’s realized and implied volatility (which drives options prices). It’s no different from the equity risk premium; investors expect a certain level of returns for taking on equity risk.
To maximize returns, a covered-call ETF should optimize these risk/return tradeoffs instead of focusing on a specific level of income. Unfortunately, this introduces market timing risk. When market movements go against a manager’s expectations, these strategies can underperform basic covered-call ETFs.
Income: Cash Flow vs. Total Returns?
Most investors use covered-call ETFs as income funds, since selling call options generates a high level of cash flow up front. This confuses cash flow with total returns and overlooks foregone opportunities. Cash flow can come from many sources: stock dividends, bond interest payments, annuity payments, or simply profits from liquidating positions. Each have different consequences for your taxes and portfolios. At the end of the day, a portfolio’s total return (which includes all unrealized capital gains and distributed income) is the most important consideration for future cash value.
Investors with high cash needs should compare covered-call ETFs against other sources of distributions, paying special attention to their impact on total return. Consider the performance of the BMO Covered Call Canadian Banks ETF ZWB with its underlying stock strategy, the BMO Equal Weight Banks ETF ZEB. Over the past 20+ years, the covered-call ETF sorely missed many market rallies and trailed ZEB by more than 2 percentage points annualized. The call premiums offered some protection during market crashes but failed to compensate for the lost upside. In this instance, investors would have been better off holding ZEB and selling shares themselves to generate income.
Covered Call ETFs Often Lag Their Underlying Stock Portfolio Over Longer Periods
Source: Morningstar Direct. Data as of 02/28/2025.
Tax, Tax, Tax
Covered-call ETFs typically pay out a combination of eligible dividends, return of capital, and capital gains. Eligible dividends receive the lowest marginal tax rate of these methods, as they enjoy a preferential federal dividend tax credit. But a covered-call ETF can’t distribute all its income this way. Investors often receive a sizable portion of their yields as return of capital. These distributions are tax-free when received but lower an investor’s cost basis. This could result in larger capital gains taxes when the shares are sold. While the tax rate on capital gains is lower than ordinary income tax rates, investors should pay attention to the cost basis on their covered-call ETF shares to avoid a surprise tax bill.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
