Has the New Tax System Given Covered Call ETFs their Moment?

Sometimes an investment product sits on the shelf, largely unloved, for many years before suddenly coming into favour.

Tax paid ten year insurance bonds are a great example—booming back in the 1980s before wilting for many years and then becoming a more popular choice once again in the light of the federal government’s changes to capital gains tax and negative gearing.

Those same changes, which reduce the tax effectiveness of capital gains in favour of dividend and income earnings, may bring a new lease of life to a product known as a covered call ETF.

Unlike insurance bonds, covered call products in Australia have arguably never really had their time in the sun, although they are extremely popular products in many other markets, particularly Canada.

Poor Performance a Factor

The reasons why covered call products have not become as popular in Australia centre around higher investment fees compared to simpler ETF products and also around the lower overall performance of such products compared to a straight index or growth oriented ETF.

To explain how covered call products work, they are basically a conventional growth or share index ETF product but then aim to also produce higher dividend income by selling off some of the upside for the share assets they own.

They do this by selling call options on parts or all of their portfolio to other investors—often hedge funds—thus earning extra income.

If the share market goes sideways, the premium on that call option is often paid without any change to the underlying share assets, which is a big win for the ETF.

Rising Markets Can Hurt

Alternatively, if the share market goes up strongly, at least some of those covered calls will hit their strike price meaning any further upside on that share shares is paid to the owner of the call option instead of the owner of the ETF.

This can result in a situation where the relative net assets of the ETF fall over time, even if the income to the investor remains strong.

The income produced by covered call products varies according to the design of the ETF.

While the general share market might pay dividends of around 3 to 4%, these products can deliver yields of up to double that and sometimes even as high as 15%.

In general terms, the higher the yield over time, the more capital gain is effectively being paid out in the form of income.

Income returns are generally paid monthly so a covered call ETF can be very attractive investment for retirees or other people who need strong reliable income flows.

The problem is that when fund managers have compared the performance of covered call ETFs in Australia with simply buying an index ETF, the covered call products have underperformed—some of them quite badly.

The reason for that is partly that markets have been gently rising for a long time, meaning that much of the upside of the shares has been effectively sold off while that share is rising fast, while the higher management fees have also eaten into returns.

Benefit from Tax changes

All of that might now change in after tax terms given that share market income is now taxed more leniently than capital gains, which under the new system will attract a minimum 30% tax rate on real gains after discounting for inflation no matter what the owner’s marginal tax rate on other income happens to be.

In other words, those buying covered call products may not mind giving up some of the heavily taxable capital gain available on the share market as long as they can enjoy higher income which will be subject to their own marginal tax rate rather than the heavy 30% minimum on real capital gains.

That marginal tax rate may be as low as zero for some retirees who largely live off their super in pension mode or the age pension, depending, of course, on the amount of other earned income and the total income earned by the covered call ETF.

Covered call ETF products listed in Australia cover a wide range of underlying assets with some of the larger ones being Betashares Australian Top 20 Equities Yield Maximiser Complex ETF (ASX: YMAX), which covers the ASX 20; Betashares S&P 500 Yield Maximiser Complex ETF (ASX: UMAX), which covers the S&P 500; and Global X S&P/ASX 200 Covered Call Complex ETF (ASX: AYLD), which covers the ASX 200.

No Free Lunch

Most of the research done on Australian covered call products has shown that they underperform vanilla index funds over the same assets over time so they are definitely not giving you that extra yield without a tradeoff.

The extra yield is effectively eroding capital returns, but that still might make them a very appealing niche satellite product rather than a core holding.

However, with the tax changes less than a year away, considering a covered call strategy for generating part of your income may be worthwhile.

I doubt they will ever become as popular for income investors as traditional passive yield products such as Vanguard High Yield (ASX: VHY) or the popular large listed investment companies such as Australian Foundation Investment Co (ASX: AFI) or Argo Investments (ASX: ARG).

Nevertheless, if you are prepared to trade off some future capital gains for extra income and potential tax effectiveness, covered call products may still play a valuable role.