About the intelligent investor
The weekly column of ‘The Intelligent Investor’ by Jason Zweig, has been published in the Wall Street Journal for about a decade and is published exclusively in Globes. According to Zweig: “My goal is to help you distinguish between the good advice and the one that just sounds good”
About Jason Zweig
One of the senior journalists of The Wall Street Journal. Author of the book “Your Money and Your Mind: How Neuroscience Can Help You Get Rich”, and the editor of the updated version of the bestseller “The Intelligent Investor”, described by Warren Buffett as “the best investment book ever written”
After all, it is possible to earn an income of 4% or more on cash and bonds. What if you could receive monthly dividends on stocks at an annual rate of at least 11%?
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This is the offer advertised by ETFs that generate eye-popping returns by selling option contracts. These hedge funds, known as option-income funds or covered-call funds, also protected investors from some of the blows the stocks suffered last year.
It should be understood that these funds are not magic. They cannot make risks disappear. Instead, they remove one type of risk, and replace it with another. In other words, these funds are not a way to beat the market. But for some investors, they can be a potentially useful tool for portfolio diversification.
Covered call funds (covered call options) squeeze large amounts of cash out of stocks, and provide limited protection against losses should stocks decline. The price of this is that they do not allow their holders to capture the entire market yield of the shares.
Such options-income funds provide distinct and fairly predictable performance in different types of markets. They tend to perform best in what financial professionals call “sideways markets,” when stocks don’t move up or down in a big move. In bull markets, these funds will lag behind conventional funds.
When stocks go down, Coward Cole funds often go down less than traditional portfolios. Last year, the JPMorgan Equity Premium Income ETF lost 3.5%—a much better performance than the S&P 500’s horrendous 18.1% decline. As tech stocks tumbled, the Global X Nasdaq 100 Covered Call ETF lost 19%—far less than the Nasdaq’s 32% plunge. K himself.
The possibility of receiving most of the profits when the market is on the rise, absorbing less of the losses and receiving large and regular dividends along the way, sounds like heaven for investors. No wonder JPMorgan’s fund grew by $12.9 billion in new money last year — the most in a single year by an actively managed hedge fund ever.
Coward Cole’s three Global X ETFs, linked to the Nasdaq 100, S&P 500 and Russell 2000 indices, have attracted a combined $5.2 billion in 2022. So far in 2023, roughly $3 billion more has flowed into these four funds alone.
Most of the funds’ income comes from premium payments
Before you jump on the bandwagon, however, you should learn a little about how these funds work.
In covered call trading, or covered call options, you sell a call option on an asset that you own. This gives the buyer of the option the right to buy the property from you at a predetermined “strike” price on or before a certain specified date. In exchange for this, you earn an upfront payment known as a premium. This is where most of the income these funds make comes from.
If the property falls in price, the seller can allow the option to expire, and buy the property elsewhere, at its current, lower market price. So you lost money on holding the property, but the premium from the option at least provided you with some cushioning.
What if the asset rises above the strike price? So the buyer of the option has the right to buy the property from you at the strike price. You will still earn the premium – but now you will no longer own the property, and you will not receive any future profits, unless you buy back the call option at a loss.
Funds can induce such a pattern of returns directly by trading options, or indirectly through specially tailored debt securities, as the JP Morgan fund does.
Covered calls work best “when the stock or asset you’re trading doesn’t move too far in any direction,” says Stephen Piglewski, professor emeritus of finance at New York University and a former Wall Street options strategist. “If it goes up a lot, you’ll be kicking yourself for selling the call option. If it goes down a lot, the premium won’t cover all your losses on the stock.”
The price: a significant lag behind rising market indices
In 2023, when stocks opened the year with big gains, funds of this type lagged behind – because by their very composition they are exposed to stocks by less than 100%.
This week, with S&P 500 gains reaching 8% so far this year, JPMorgan’s Equity Premium Income hedge fund rose only 1%; The Global X S&P 500 Covered Call fund rose less than 5%. This is a price that must be paid.
In 2021, when the S&P 500 was up nearly 29% and the Nasdaq 100 more than 26%, the JPMorgan fund was up less than 22%; the Global X Nasdaq 100 Covered Call Fund was up slightly more than 10%
Funds of income from purchase options are a convenient and not particularly expensive way to generate a high monthly return in cash from stocks. And if stocks move lazily during a period of sharp volatility, you’ll probably get better performance in those funds than you would in the stock market as a whole. “There are no free meals,” Reiner says.
The word “option” comes from the Latin verb “optio” – “I choose”. Before you choose to purchase one of these mutual funds, make sure you understand the trade-off that is built into your choice.