How to use premium-income ETFs to turn volatility into profits

Selling (or “writing”) options on a portfolio to generate income has become more popular over the past two decades. The strategy took off in the zero-interest-rate era following the global financial crisis and got another boost when central banks took interest rates below zero again in the pandemic.

Investors collect a premium when they write call options on their existing shareholdings (known as “covered calls”). The logic is simple: you can earn ongoing income from a stock you already own if it doesn’t pay a dividend and pick up an extra bonus even if it does. However, trading options is a complex business and can be costly if you don’t know what you’re doing. So there have been many attempts to create products that let individual investors use this strategy in a simpler way. These include premium-income ETFs – exchange-traded funds that hold a portfolio of stocks, write options on them and (typically) pay monthly distributions from the proceeds.

Premium-income ETFs have begun to hit the mainstream in the UK. The JPMorgan Global Equity Premium Income Active ETF (LSE: JEGP) and the JPMorgan Nasdaq Equity Premium Income Active ETF (LSE: JEQP) have over £1 billion and £2 billion in assets, respectively, while the Global X Nasdaq 100 Covered Call ETF (LSE: QYLP) has amassed around £0.5 billion.

There is also a fast-growing range of smaller products. In total, European investors have access to 57 such ETFs, according to ETF data provider ETFGI. Assets under management stood at $5.6 billion at the end of March after year-to-date inflows of nearly $1 billion.

A different approach with premium-income ETFs

Trailing yields on the most popular premium-income ETFs range from 7.7% for the JPMorgan US Equity Premium Income Active ETF (LSE: JEIP) to 11.5% for QYLP. This is much higher than the yield on a typical high-yield ETF and reflects a very different strategy.

“Option-income ETFs generate income through writing call options on stocks they hold as well as the dividend income, which is usually much lower than the options income,” notes Tom Bailey of HANetf, the ETF platform that issues the YieldMax and Rex covered-call ETFs. So while a dividend-income fund can only own stocks that meet certain yield criteria, a premium-income ETF selects stocks on their potential to earn high options premiums.

The need for liquid options markets pushes these premium-income ETFs into larger and more liquid equities, but usually different ones from a typical income fund. “Highyield ETFs often hold energy, utilities, consumer staples and other reliable dividend payers. Premium-income ETFs, by contrast, will often hold technology stocks,” says Bailey. This can provide investors with a degree of diversification in their income portfolios that they may otherwise have rejected due to a lack of dividend yield.

Premium-income ETFs aren’t a replacement for income funds

Investors shouldn’t view premium-income ETFs as a simple replacement for income funds. Dividend stocks tend to be less volatile than other equities, which translates into lower volatility for your portfolio value. Tech stocks are far more volatile, so while they may help the fund generate more income, that will come at the expense of bigger swings in the portfolio.

What’s more, selling call options on the underlying asset means that premium-income ETFs cap equity upside (if a stock goes up a lot, the option buyer will exercise their right to buy the stock from you). So investors are trading off a few percentage points of long-term capital gains every year for immediate income returns.

Note, too, that income is not guaranteed. Options prices are volatile and depend on multiple factors: premiums and income generated will spike in periods of volatility and fall when markets are calm. For example, YieldMax Big Tech Option Income ETF (LSE: YMAP) is on a trailing yield of 27%, but that depends on high volatility in tech. Managers can sell more options to enhance the income, but that would increase leverage and risk. However, despite these drawbacks, there’s clearly a growing market for these funds.

This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.