The Total Stupidity of Owning CC ETFs

Investing Strategies Retirement Investing
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To see how this is so, use your favorite broker’s screener for ETFs and ask to see those that pay weekly divs and are reported to have a distribution yield greater than 8%. Schwab nominates MARO as fitting that screen, and they report its distribution yield to be a whopping 265.98%. But now here’s the skinny on that yield. It comes at the cost of share price loss.

To see how this is so, let’s do a paper trade on MARO and buy it the day after its div date at market close. Just to make things interesting, let’s do our pretend buy on Nov 21. Our price per share was 8.94. Since that time, we’ve collected $1.09 in divs. But our share price today, Jan 23, is an underwhelming 7.81. Opps.

So, let’s do that basic, 4th grade arithmetic I referred to. On Nov 21, We spent 8.94 to buy one share of MARO that is now worth just 7.81 today, Jan 23. That’s a loss of 1.13. But that loss is offset by having received 1.09 in divs. So, which is the bigger number? The loss of $1.13, or the gain of $1.09? That is such an easy question that even our putative 4th grader could answer it.

In short, buying CC ETFs for the sake of receiving a periodic, but highly variable, income-stream is a loser’s game.

Disclaimers: I haven’t run this exercise on every CC ETF marketed by Wall Street’s scammers, nor have I done comparisons on the total return offered by every CC ETF vs the total return that would have been achieved from owning the underlying over the same holding period.

But I’ve done enough of both exercises to suspect that covered call ETFs are a waste of time (and money) and that an investor would be far better off avoiding the scam altogether or by owning the underlying and writing the calls her or himself instead of being lazy and buying a pre-packaged product.

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One other hilarious thing about these funds is what the proponents themselves say about them. Here’s a rough description of a recent conversation I saw about them (somewhere on social media).

Skeptic: How can you have such a high yield?
Proponent: Derivatives are used to create that yield.
Skeptic: Aren’t all those gains considered ordinary income and taxed at the highest rate?
Proponent: No! Much of the gains, in this particular fund we are discussing, 92% of the dividend is considered ROC (return of capital) and isn’t taxed at all.
Skeptic: Aha, interesting. If it return of capital, what happens after 9 years in the fund? The yield is 12%, if 92% of that is return of capital, then after 9 years, nearly all the capital (about 99%) has been returned. What happens after that? And where did all that return of capital come from exactly?
Proponent: The fund managers are doing a good job, they will deal with that.

Basically no answer. Does anyone here have an answer? I’d guess that all those funds will simply shut down by then, so nobody will ever have to deal with it.

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Isn’t it straightforward? When cost basis is down to zero, any ROC is a capital gains and taxable from that year forward.

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Mark,

My suspicion is that the conversation on CC ETFs you related wasn’t about CC ETFs but another product. The divs paid out by CC ETFs do come from the prems collected by the writers, not from return of capital. Were the latter the case, the CC ETF would go to zero. But that isn’t the typical case. The typical case with the pair is that the derivative tracks the underlying with a close to 1.0 correlation, but under-performs it in terms of the total gain an investor would receive if he/she bought both at the same time and held both for the same amount of time.

Why the under-performance? At least two reasons. The call writers are retaining some of the prems collected as their own profit, and maybe and probably, they aren’t very skilled call writers.

Below is a chart that compares MAGS, the underlying and the blue line, to its derivative, MAGY, in which the divs paid out have been backed into the price plotted for MAGY, which is the black line.

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The exercise I haven’t yet run on these pairs is the following. Sometimes, the underlying itself pays a div. Generally, that div is smaller than those paid out by the CC ETF and paid less frequently, such as quarterly rather than weekly. So, here’s the math problem. Let’s assume a pair is bought and held for a year and a day and then sold, so that any cap-gains from either are taxed at LT cap-gains rates. Let’s also assume that all divs received from either are instantly reinvested in the instrument that produced them.

It’s not obvious to me, without doing the math , that the CC ETF couldn’t sometimes out-perform the underlying, because it enables the rapid redeployment of capital. However, the typical buyer of CC ETFs isn’t putting the divs back to work. They are spending that income-stream as fast as it received and then, at tax time, having to pay ord-inc taxes on those divs, which degrades the supposed gain from the instrument.

[Later. I ran the div reinvestment exercise on a CC ETF. Doing so just exacerbated the losses an investor would have sustained. That was just one CC ETF. So the result might not hold for all of them. But the more I dig into CC ETFs, the more obvious it becomes to me that they are the equivalent investment of a black hole and better avoided in favor of simpler, more traditional vehicles. YMMV, of course. ]

Also, if the exercise is to be realistic, the impact of inflation, week by week and month by month, on the purchasing-power of those divs needs to be tracked . Sounds complicated. But it’s simplicity itself to do in a spreadsheet once the formulas are set up.

Basically, the problem of choosing between them, i.e., whether to buy the underlying or a derivative of the underlying, is a matter of calculating which vehicle could produce the most after-taxes, after-inflation, total return over the same holding period, and the problem of owning either is that both could easily result in the loss of a lot of money. So, buying either and turning a profit on their purchase is a matter of disciplined market timing, which is an anathema for most “investors”.

If it’s a steady, predictable, nearly assured income-stream they want, they should buy instruments created for that purpose, not try to use derivatives as bonds.

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