On their own, income and downside protection are alluring prospects for advisors and clients alike. Add convenience to the mix, and clients are likely to be intrigued.
Covered calls, including in fund form, are solid avenues for generating income outside the realms of stocks and bonds. This strategy is increasingly accessible via exchange traded funds, many of which sport big yields and tolerable expense ratios. Plus, the asset class is pertinent in the current environment.
Covered call strategies are often rewarding in turbulent market settings because options premium move higher, meaning more income to options writers or sellers. Covered call ETFs are just one example of options writing in fund form.
Funds such as the Nationwide Nasdaq-100® Risk-Managed Income ETF (NUSI) offer clients the combination of big income with some downside protection. Actively managed, NUSI sells covered calls on the Nasdaq-100 Index (NDX), which isn’t known for having a big dividend yield. As highlighted by a yield of 7.42%, NUSI reinvents the proposition of Nasdaq-100 income.
NUSI: Income and Volatility Benefits
The NUSI story is compelling, but it doesn’t revolve solely around income. Other perks include the ETF’s potential ability to reduce portfolio volatility and its status as an alternative investment.
“Investors want to protect their money, reduce volatility, and generate more net after-tax income. In addition to receiving dividends and interest on equities and fixed income securities, they’re looking for alternative products that generate tax-efficient income – ideally ones that aren’t highly correlated with other income buckets,” said Garrett Paolella, Portfolio Manager of the Nationwide Risk-Managed Income ETFs, in interview with Nasdaq.
Of course, income is a significant part of the allure with NUSI and advisors should understand the mechanics of this fund in order to better articulate its benefits to clients. Translation: Methodology matters.
“The rules-based option strategy is unique in that there are built-in triggers that indicate – based on years of data and research – opportune times to close the short call,” adds Paolella. “For example, if most of the option premium has been captured or if the market moves higher, the model may indicate that it’s time to close the call, potentially “uncapping” the portfolio and allowing the underlying portfolio securities to appreciate alongside the NDX.”
The aforementioned NUSI benefits don’t preclude clients participating in some – emphasis on “some” – of NDX’s upside. For example the fund is higher by 11.24%. That’s just 1% behind the S&P 500 with nearly five times the yield.
NUSI Tax Implications
Due to the fact that it’s not a run-of-the-mill equity or fixed income ETF, there are different tax implications with NUSI. Notably, options are taxed using the 60/40 rule – 60% long-term capital gains and 40% short-term.
That can result in more favorable treatment than what clients are subject to realizing gains on individual stocks or equity-based funds.
“The tax-deferred nature of the income distributions reduces your cost basis in the Fund, but again that may allow investors to earn about a 7% tax-free distribution each year they hold NUSI. Even with interest rates where they are today, that’s a significant net after-tax yield,” concludes Nationwide’s Paolella.