Quick Read
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Higher yield comes with trade-offs: Covered call ETFs generate double-digit distribution rates by harvesting option premiums, but investors should expect capped upside during strong bull markets.
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Tax efficiency stands out: The NEOS funds use Section 1256 index options and tax-loss harvesting, leading recent distributions to be largely estimated as return of capital.
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Choose based on market exposure: SPYI offers broad market exposure, QQQI targets the higher-volatility Nasdaq-100 for larger premiums, and IWMI pushes yield even higher through the greater volatility of Russell 2000 small-cap stocks
Covered call ETFs are often described as “selling upside in exchange for income.” While that’s directionally true, it’s an incomplete way to think about how the strategy actually works. Option premiums are largely driven by the market’s expectation of future volatility.
If the volatility ultimately realized by the underlying security comes in lower than what was implied when the option was sold, and time decay steadily erodes the option’s value, the option seller comes out ahead by harvesting those premiums. That means covered calls tend to work best in certain market environments, particularly range-bound, volatile markets.
The 2022 market, characterized by rapidly rising interest rates, persistent inflation, and repeated rallies that ultimately failed, is a good example of the type of environment where covered call strategies can shine. Long term, however, total return remains what ultimately matters. Covered calls will often trail a strong bull market because of their capped upside.
Still, if generating a higher stream of cash flow helps you stay invested through market volatility, they can be a useful tool. Today we’re looking at three ETFs from NEOS Investments that target different segments of the U.S. equity market while generating headline distribution rates ranging from roughly 12% to more than 14%.
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I generally prefer these ETFs over many of the older covered call funds because they write index options classified as Section 1256 contracts, which receive the favorable 60/40 blended capital gains tax treatment regardless of holding period. Combined with tax-loss harvesting inside the portfolio, a substantial portion of their distributions has recently been estimated as return of capital, which generally reduces an investor’s adjusted cost basis and defers taxes instead of generating immediately taxable ordinary income.
NEOS S&P 500 High Income ETF (SPYI)
For investors seeking covered call income from the broad U.S. market, NEOS S&P 500 High Income ETF (SPYI) currently offers a 12.04% distribution rate while charging a 0.68% management fee. Unlike many traditional covered call ETFs that simply overwrite an index, SPYI actively buys and sells S&P 500 index options. That additional flexibility can improve upside participation while still generating meaningful option premium.
The strategy has produced respectable results. Since inception, SPYI has generated a 14.65% annualized total return, outperforming the Cboe S&P 500 BuyWrite Monthly Index, which returned 11.91% annualized. It still trails the S&P 500 Total Return Index, however, which returned 18.80% annualized over the same period. That’s the trade-off investors accept for generating higher current income.
Tax efficiency has also been encouraging. According to the fund’s latest July 19a-1 notice, approximately 99% of the most recent distribution was estimated to be return of capital. Investors should remember these notices are only estimates. The final tax treatment is determined after year-end and reported on Form 1099-DIV.
NEOS Nasdaq-100 High Income ETF (QQQI)
The Nasdaq-100 historically experiences greater price volatility than the broader S&P 500. Since option premiums generally increase alongside expected volatility, covered call writers receive larger premiums for taking on that additional risk. That’s reflected in NEOS Nasdaq-100 High Income ETF (QQQI), which currently offers a 14.01% distribution rate while charging the same 0.68% expense ratio.
Performance has followed a similar pattern to SPYI. Since inception, QQQI has delivered an 18.02% annualized total return, outperforming the Cboe Nasdaq-100 BuyWrite Monthly Index, which returned 14.01% annualized. However, it still trails the long-only Nasdaq-100 Index, which produced 21.75% annualized over the same period. The latest July 19a-1 notice estimated that 100% of the distribution was return of capital. As always, investors should remember this remains an estimate until final tax reporting is completed after year-end.
NEOS Russell 2000 High Income ETF (IWMI)
Among the three funds, NEOS Russell 2000 High Income ETF (IWMI) currently offers the highest payout, with a 14.30% distribution rate. That higher yield reflects the greater volatility typically found in small-cap stocks.
Companies within the Russell 2000 generally have less established businesses, lower profitability, and greater sensitivity to economic data and financing conditions than large-cap companies. Greater uncertainty produces higher implied volatility, which in turn creates richer option premiums for covered call sellers.
Since inception, the ETF has produced an 18.05% annualized total return, comfortably ahead of the Cboe Russell 2000 BuyWrite Monthly Index, which returned 13.72% annualized. Even so, the long-only Russell 2000 Index still leads with a 20.63% annualized return.
The July 19a-1 notice estimated that approximately 86% of the most recent distribution was return of capital. While somewhat lower than SPYI and QQQI, it still represents a relatively tax-efficient distribution mix. As with all 19a-1 notices, investors should treat this as a preliminary estimate until the year-end Form 1099-DIV is issued.
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