Covered Call ETFs SPYI & GPIX Upside + Downside (undefined:SPYI)

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Jack Bowman dives into covered call ETFs SPYI and GPIX (0:25). Advantages of ETF structure (2:10). Different mechanics of SPYI and GPIX (4:20). Dividends and fund criticism (7:00). Tax implications (9:35) Catch the full video presentation (with charts) here.

Transcript

Daniel Snyder: Today, we’re diving into the world of income via covered calls in the ETF space with none other than Jack Bowman. You know him already, an analyst over here at Seeking Alpha. Thank you so much for joining us today, Jack.

Jack Bowman: Daniel, thanks for having me on.

DS: So why don’t we kick this thing off with just talking about (BATS:SPYI) and (NASDAQ:GPIX) and give us the overview of these funds and what they do.

JB: They are covered call funds, which essentially means that they’re buying long stock. In this case, they buy the components of the S&P 500 (SP500).

So just like (SPY), they are 8% NVIDIA (NVDA), 6% Apple (AAPL), or whatever the weights are. But they put an overlay on top of it. So they sell covered calls which are short call options that generate premium.

And this is where they get their income from. So while SPY, the S&P 500, might yield 1%, these funds are able to yield anywhere from 8% to 12% because of this covered call overlay.

It comes with some downsides. It limits their upside, but these funds are unique because they are working on ways to remove that upside cap as much as possible. And they do it in a unique way that we haven’t seen in other covered call funds before.

The real advantage, I think, of these over the old way we used to do things is that markets have become so volatile. And we saw this in April, is that if you’re not managing the options, you’re not working with the upside cap, you’re not working with the market as it churns, you can get left behind.

This was a long criticism of covered call funds that these funds don’t tend to have as much. They still lag a little bit. All covered call funds will lag on the upside. But they tend to experience much more of it.

And they have different mechanisms that allow them to participate in upside in a way that some of the older funds don’t.

DS: So let’s talk about you’re talking about managing the option strategy. What are your thoughts about whenever somebody goes to buy and sell an option, they’re paying commissions still, right?

This is one of those assets that or the parts of the market that still has a commission fee base behind it. So obviously, what are your thoughts on that also eating into the return of the overall fund?

JB: Yeah, so this is one of the advantages of the ETF structure, is these ETFs have become so large that they have a lot of purchasing power in the market in terms of these options commissions. When you’re a retail trader, you’re kind of beholden to whatever your broker charges for commissions. But when you’re managing a fund of hundreds of millions or a billion or plus dollars, you have a lot more pull.

And so these funds tend to work with options not in the same way that retail traders do. They tend to work with very bespoke options contracts. They have much lower spreads. They tend to get all of the terms that they like. They’re called flex options.

They’re run through the OCC or the Options Clearing Corporation, which also means, they don’t have the same counterparty risk. So when you sell an option, you have the risk of being called. The person exercises the option, you’re forced to sell your shares and now you have to start over. But when you’re selling these options as a giant ETF you don’t have that risk, that risk is pulled out of it.

And that’s been one of the huge advantages for not only just having a manager run the fund, but also getting rid of some of the options risk.

There’s also the risk when you sell your own options that you could do poorly. If you’re not an experienced options trader, it can be very daunting. And so the ETF format takes some of that risk away because you have a manager who does this all day long for a living. And of course you do pay for it, right?

Instead of the options spread and the options commissions, you pay an expense ratio for the ETF. So, there’s always going to be a cost to it, but I see the cost on the ETF format is lower and that’s very beneficial for a lot of traders.

DS: Yeah, thank you for that. I’m wondering if you could walk us through each of these funds have a version of what’s referenced most of the time as a catch-up mechanic. If the market pulls away and they’re lagging too much, they dive in and they actively trade kind of like you are talking about.

Would you be able to walk us through the SPYI and the GPIX versions of that?

JB: Yeah, absolutely. So what makes them so interesting and why I’ve been covering them, is that traditionally, once you hit your upside cap, you’ve hit your top of the option, wherever that strike was. You’re capped on the income for the month, see you next month. Both of these funds have different mechanics to work around that.

So SPYI has two mechanisms it uses. One is that it rolls its upside option, its call option consistently. So it may be trading once a day, once a week, more than that. I don’t follow the funds intraday flows, so I don’t know how often they trade, but I know that it’s frequent. That leads to some turnover but it also leads to more upside over time because they’re able to adapt to ongoing market conditions.

They also have, and I don’t think they’ve deployed this. I was listening to an interview with the portfolio manager on YouTube, and he was saying that we’ve never used this, but they have the ability to buy long calls, which would provide extra upside at certain opportune times.

I thought they would have deployed this in April because of how quickly they caught up after the market crash and correction, but they didn’t according to the portfolio manager. So they have the option if they need.

For options people, this would create like a credit spread basically that would allow you to not only cap your upside, but cap your downside to a certain degree.

GPIX is a little different. They use a strategy called dynamic overwrite, where essentially they’re modulating the amount of the portfolio that they sell calls on. So it- the bottom in April, they were very worried about, well, what if we rebound, go right back up, which we did. And so they sold on a much smaller portion of the portfolio.

It reduced income, which at the time people were a little bit upset about, but once they saw why, right, the market started to go back up and GPIX had more upside participation. It kept up with the market better and the income has come back.

Now that we’re back to higher levels, they can write on a larger portion of the portfolio. They see us back towards all-time highs. So they can modulate back up again and generate more income. It leads to this more variable structure, but it also leads to a fund that doesn’t decay over time. It’s been one of the big issues that a lot of covered call ETFs have had, is they slowly grind down over time. And these two strategies, the catch-ups have been working so far.

DS: You mentioned, April, the Liberation Day, volatility spike, market pullback. But as you mentioned, we’ve climbed back and we’ve exceeded where we were at the time.

With these funds being newer to the market, how do you expect them to react further? You say it was 2022 or any other bear market, how would you expect these funds to act during those times?

JB: Yeah, so this is one of the big criticisms that I can levy on these funds is that they’re really new. And because of that, we don’t have the back data to say, well, they survived 2008, or they survived dot com, or they survived the COVID crash. They did survive the April crash, but the April crash was really quick.

I kind of make this joke as like, if you fell asleep on March 31st, and you woke up on April 31st, you had no clue what happened to the market. To you, your account looked almost the same because of how fast it was.

So these funds will tend to, on the downside, be a little padded, not because they hedged the downside, but because on the way down, they’re distributing income. So the dividends still hit your account, that counts as return, and because the dividends are paid in cash, they don’t fall with the ETF unless you’re reinvesting.

And so they tend to experience a little bit less downside, not that much less. In sideways markets, let’s say from 2001 to 2011 we had the lost decade where stocks basically for, oh they were flat for 10 years not because they were 0% returning for 10 years but because by the end of the roller coaster it was basically the same level.

These funds should in theory, and we don’t know because we haven’t seen it happen yet, but they should in theory do very well and outperform the market because they’re profiting off the volatility along the way. So you’ll still get paid those dividends, those dividends should increase the more volatile we get. Down markets, sideways markets and up markets.

So on the upside, though, they lag. And this is true for basically all income products and covered call funds. They tend to lag a little bit. These products lag significantly less than some of the older covered call funds. But we should expect them to underperform in bull markets.

And this is because we’re solving for risk, right? The income is solving for the sequence of returns risk of hoping stocks go up, so you can sell them and make money. Instead, you’re getting the income paid to you, but that comes with giving up some of your upside. So in bull markets, they’ll underperform.

DS: I want to talk about the tax implications because that was something that you’ve written about recently as well. Can you just walk every viewer that’s watching right now, walk them through why these are so favored because of the tax status and how they’re treated?

JB: This has been one of the ways in which these options selling funds have had such an advantage over traditional bond funds and other things that pay coupons or ordinary income. In that, the IRS classifies options income when it’s made inside the ETF and distributed to shareholders, they classify it as return of capital.

It’s not necessarily the same return of capital we see in dividends that are actually just returning your money to you. It is the premium earned from options, but it’s classified as return of capital. And return of capital is a little special because it doesn’t count as income earned in the year that it’s distributed.

So if you got a dividend tomorrow, you wouldn’t owe taxes on it. Instead, it’s counted against your cost basis for the shares. So if you got $1 in income, your cost basis was $25 a share, now your cost basis is $24.

That’s a capital gain. And you can sit on capital gains for a very long time. This means you can defer the taxes. So you still owe the taxes on the dividends, but you can defer them. You can choose when to sell the shares that realizes the capital gains.

The big interesting part of this is, and some people have been talking about this, is like, well if you hold it forever and eventually your cost basis gets to zero, then what happens? Well, you would owe the entirety of the share price in capital gains when you eventually decide to sell them.

But any future income after that zero point is classified as long-term gains in that year. For most people, the long-term capital gains rate is lower than their income rate for taxes. So it typically leads to a lower tax bill. And I say typically here because everyone’s situation is so different for taxes.