These 6 Income Funds Use Options to Pump Up Their Yields

The big lure of the ETF and similar funds is, unsurprisingly, income. The ETF has a trailing 12-month yield of 11%, way above traditional dividend-oriented funds and ETFs that yield in the 3% range.

The difference is the income produced by the sale of call options. The funds give up appreciation potential in return for options income. They are best suited to retirement accounts because the options income tends to be treated as a short-term gain and thus taxed as ordinary income, according to New York tax expert Robert Willens.

Call options allow the holder to buy a stock or index at a fixed price during a set period. Call-option sellers pocket premium income but relinquish the ability to benefit from gains above the strike price of the options.

“The strategy works in many market environments,” says Hamilton Reiner, a manager of the JPMorgan Equity Premium Income ETF. He says the fund should do well in “range-bound markets” because of ample options income. That income also should offer some protection in down markets. “It won’t outperform but will get a good chunk of the gains in an up market,” Reiner says.

The ETF aims to generate 75% of a rising market’s total return with a beta, or expected volatility relative to the market, of 65%. It has nearly matched the S&P 500’s total return since its inception in May 2020. During 2021, it returned 21%, about 75% of the S&P 500’s total return, and it protected investors last year, losing just 3%, against an 18% loss in the S&P 500, helped by options income and a portfolio that bested the index.

This year hasn’t been as good. The fund is up 3%, way behind the S&P 500’s 8% total return. The ETF tends to write options that are 2% to 4% above the S&P 500 level, leaving room for appreciation potential.

All these funds face a trade-off. The closer the options are to market levels when written, the higher the income but the lower the appreciation potential. Eric Boughton, a portfolio manager at Matisse Capital, which invests in closed-end funds, urges caution.

“Call writing reduces the volatility of these funds as compared to the stock market, but it also acts as a drag on returns relative to the stock market in most time periods,” he says. “In general, call writing limits upside participation in market gains much more than it protects against market downside pain.”

The success of the JPMorgan Equity Premium Income ETF has spawned the
JPMorgan Nasdaq Equity Premium
ETF (JEPQ), which has grown to $2.1 billion in less than a year. It has a higher yield of about 12%, reflecting greater volatility of leading Nasdaq stocks like
Microsoft
(MSFT),
Apple
(AAPL), and
Alphabet
(GOOGL). When market volatility is high, options prices are higher, and that results in more income for the funds. Overall volatility as measured by the
Cboe Volatility Index,
or VIX, is now about 17, lower than the average of recent years.

Other sizable ETFs in the category include the $7 billion
Global X Nasdaq 100 Covered Call
(QYLD) and
Amplify CWP Enhanced Dividend Income
(DIVO).

There also is a large group of closed-end funds pursuing the strategy, including
Eaton Vance Tax-Managed Global Diversified Equity Income
(EXG) and
Voya Global Equity Dividend & Premium Opportunity
(IGD).

The funds pursue varying strategies based on portfolio composition and use of options. The Amplify fund owns a portfolio of about 25 quality stocks—many of which are in the Dow Jones Industrial Average—led by Microsoft,
UnitedHealth Group
(UNH),
Visa
(V), and
Chevron
(CVX).

Amplify founder Christian Magoon says the fund, with a five-star rating from
Morningstar,
differs from some peers because it writes options against only a portion of its portfolio.

That results in a lower yield of about 5%, but it helps generate strong performance in rising markets—such as in 2021, when it returned 22.9%. It also held up well last year, returning negative 1.5%. It’s up about 2% this year, appreciably behind the market.

The Global X ETF has an income focus because it writes at-the-money options on the index. That can generate nice income but at the expense of appreciation potential. The ETF badly trailed the Nasdaq 100 in 2021, returning 10%, against 27% for the index. This year, it’s up about 12% against a 20% gain in the index.

Boughton says investors could consider closed-end funds with international stock exposure, since they trade at some of the deepest discounts in the category.

The Eaton Vance fund holds a portfolio of high-quality global stocks led by Microsoft, Alphabet, and Apple, and writes options against a portion of the portfolio—roughly 50% at year end. The fund, at around $8, has a yield of 8.5% and trades for a 9% discount to its net asset value.

The Voya Global Equity fund, at about $5 a share, yields 9% and trades at a 13% discount to NAV. It writes options against about half of its portfolio. While global is in its name, over 60% of its stockholdings are in the U.S., led by
Johnson & Johnson
(JNJ), AbbVie, and
Merck
(MRK).

Write to Andrew Bary at andrew.bary@barrons.com