CC ETFs: Cover your asset!
I've seen a lot of posts and questions about the modern CC ETFs (SPYI/QQQI/ROCY) etc. I see a lot of potentially bad advice out there and it seemed sensible that since I make the same comments a lot, I simply post my thoughts here and get not only feedback and clarification for myself, but also have a sticky post I can refer people to instead of writing essays in their comments.
I'll bold the summarized points for the TL;DR; types and have some more in depth points about each. I'm eager to know thoughts and get clarification from anyone who is more of an expert in this space.
Many people are singing the praises of these CC ETFs and a lot of people are diving right in without knowing the risks so I'll try to highlight what they are and what the risks really are.
Please note: I am not against CC ETFs - They are tool, when used properly they have great benefits.
What they are:
CC ETFs are a covered call strategy on top of the underlying holdings so QQQI is a strategy that holds and executes calls on QQQ. Covered calls are a type of option - we won't get in the specifics of the mechanics but you are essentially buying ownership in the execution of those options to get a cut of the profits instead of running them yourself. Those premium profits are (hopefully) what you're getting paid out. Essentially you are buying a volatility based income stream.
Risk Summary:
1) Primarily driven by volatility: You aren't so much owning the performance of the underlying as owning the income stream produced by the volatility. The more inferred volatility in the market, the higher the premium, the more likely the payout stays constant or increases. If volatility shrinks then they can't get as much premium per contract and that causes the payout to fall or they have to sell assets to keep the payout steady (NAV Erosion/destructive ROC). This will generally cause income investors to sell dropping the price. This spiral continues until the volatility is able to support the distribution to bring the yield back to an attractive place. Follow the related volatility indicators (VIX / VXN / etc.).
2) Highly retail drive (Psychological Factor): Most financial advisors and investment advisors will immediately steer you away from these in a long term or retirement portfolio. This doesn't mean they're bad, it means that the majority of players in these assets are retail investors. This means they have a HIGH behavioral factor. Where institutions usually heavily influence trends in the market because they move large volume, CC ETFs don't tend to move in that and can in fact move in counter intuitive ways in the right conditions. See JEPI that has moved downward despite its underlying moving upward in certain situations - this could be a competitive effect where people are leaving for higher yield competitors. This doesn't mean that JEPI has performed poorly, this is simply to highlight that sometimes these assets move counter to what people might find intuitive due to some retail psychology factors. Don't always expect it to follow the underlying.
3) Capped Upside: The mechanical nature of a call means your potential to capture the upside when the underlying grows is limited. If it grows fast, you may miss out on large gains.
4) Asymmetric Truncation (Potential DRIP punishment) You have potentially full downside exposure. While it might lag behind as well, it will downside harder than it will cap upside so you Asymmetric Truncation - When it goes down, it will go down harder than it will recover. This almost requires that you spend more time in an uptrend than a downtrend to not get exposed to price degradation. When you DRIP, you are acquiring more quantity, but due to lack of much price appreciation there is little padding so in a big downside turn your losses are compounded down as well and with capped upside - it takes longer to recover and you require more/longer up cycles.
5) Yield Chasing Bait: While not specifically pertaining to these CC ETFs, any distribution paying asset should be evaluated by its actual payout and how its trailing yield and return on cost are performing for you. If you buy at $50 and the price falls to $40 - The distribution can fall too and still have a yield of 13%. It looks good at paper, but your actual yield on cost is much lower because you bought it at a different price. Don't just look at forward yield. If you see CC ETFs that have very high yields (15%+) - you should do a lot of due diligence to research that fund as there are many yield traps out there that will show a high yield, but expose you to repeated capital loss.
6) Demand Crowding: These funds are all the rage right now, but there must be buyers on the other end of covered calls sales. These funds can be vulnerable if demand for this type of investment shifts. This can cause yields to fall if enough calls can't be sold.
Where they perform well:
Stagnant Markets, Slow Bull Markets, High Volatility Markets
1) Raising total yield on portfolios for income right now
2) Raising total yield for secondary income streams when your retirement is well situated
3) Temporary holding during stagnant markets
What they perform poorly at:
1) Wealth Accumulation: These assets lag behind the underlying so you're better off holding the underlying to capture all the upside. If you are in the market for long term 20-40 year holds and don't want to watch your account daily, go for the growth products that these are trading on top of. If you don't need the income now, you are capping your upside potential and assuming all the downside risk to no true additional benefit. These are not set it and forget it type assets. You should monitor them weekly and be ready to reposition if market conditions shift away from being favorable.
2) Retirement: Its not very common to see these recommended to retirees because they payout can become unstable when the above mentioned factors shift. Retirement is looking for consistent income that won't fluctuate or potentially lose capital if you need to rebalance. These are too risky for holding long periods in retirement accounts unless the total capital is just too low and yields need to be buffered but even then, they will tend to pick other tools. If you choose to hold these in a retirement account, it is recommended that you monitor them periodically.
In summary: These are high risk assets that should not be used for set it and forget it portfolios. Don't think of it like you would a growth asset - you are buying the perception of an income stream - and what moves the underlying is very different from what moves the income stream. It's good to check in on them often to make sure they are still meeting your goals.
Thank you if you read this far! Happy to answer more detailed questions in DMs and if I've got something off the mark, please do post a correction and I will do my best to edit it here for accuracy of people referencing this post later.