Covered Call and Buffer ETFs: Do the Pros Outweigh the Cons?

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. What’s your peace of mind worth as an investor? The editor of Morningstar’s ETFInvestor newsletter will discuss what you should know before making this trade-off. Plus - Netflix signals changes in the future. What Morningstar thinks of the streaming pioneer’s recent success and its stock. And – our financial and investment to-do lists evolve as we age. We’ll look at what Gen Zers and Millennials should make a priority. This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

Netflix reported another incredible quarter with growth in subscriptions, revenue, and profits. The streaming pioneer added more than 9-million subscribers worldwide in Q1. Yet, it plans to stop regularly reporting membership numbers next year. Morningstar thinks this means Netflix is expecting far fewer annual subscriptions. Netflix reported revenue rose 15% year over year. Its second-quarter outlook implies that growth will accelerate. But the full-year forecast signals the opposite in the second half. Morningstar thinks the streamer’s recent level of success can’t be sustained. Morningstar raised its estimate for what Netflix’s shares are worth to $440 from $425. The stock looks a bit expensive.

United’s first-quarter revenue and profit somewhat exceeded Morningstar’s forecast. The airline reported more than $11 billion in revenue. It also blamed a $124 million loss on the temporary grounding of its Boeing 737 Max 9 fleet. Delayed deliveries from Boeing resulted in the company reshuffling its airplane orders plan. Meanwhile, United CEO Scott Kirby says the carrier established stronger relationships with business travelers and attracted customers looking for deals. Here’s how: it unbundled perks like assigned seats from core ticket prices and nixed change fees. Morningstar says the moves don’t give United a competitive advantage within the industry. United’s plans for higher and extended capital spending led to a fair value estimate change. Morningstar now thinks United’s stock is worth $35 down from $38. Shares look overvalued.

Our financial and investment priorities evolve from our first job to retirement. Life-stage investing can help people understand what they should prioritize and when. Morningstar's investing guide for every life-stage lays out the financial task that people should check off across four phases. Morningstar, Inc. Editor Margaret Giles is here to break down this concept and discuss the first two life stages.

Thanks for coming back, Margaret.

Margaret Giles: Thanks for having me.

Hampton: So, let's start with an explainer. What is life-stage investing?

Giles: Right. So, life-stage investing is basically a framework to think about these different tasks that you have to manage your finances throughout your life. So instead of just thinking, okay, I need X amount of dollars by age 30, thinking about things in life-stage helps people who maybe have slightly different timelines, take these priorities, manage them effectively. And it just makes everything more simple as you go through your financial life, your whole life. And so, we've got a way to break things down and make them manageable.

Hampton: Well, let's break down the first life stage. Early career accumulation. Who falls into this category and what should they make a priority?

Giles: Right. So roughly age-wise, that's 20s and 30s, but what's more important is to think about where are you in your career? You're just starting to earn money for the first time. So, whether that's post-college, maybe you didn't go to college, the timeline can look a little bit different. And then it's also thinking about how far are you away from retirement? So, you have a long runway. And there are lots of priorities to think about. So, I'm going to go through them.

First is planning how to pay down debt. So, taking a plan, working on your budget. The next is to keep investing in yourself. So maybe that's college, maybe that's continuing to develop there. Then you've got building a financial safety net. So that's an emergency fund, really important when you're just starting out. Then you want to – and these next three kind of all go together. So, you want to kickstart your retirement accounts. The biggest thing that you're investing for is retirement and you've got a long time to do it. Then you want to focus on tax-sheltered vehicles. So that can give you benefits and savings down the line. And then you also want to consider Roth accounts in this life stage particularly. Lastly, you want to invest in line with your risk capacity. And you want to use simple, well-diversified building blocks to build that portfolio.

Hampton: Now, you mentioned Roth accounts, early career accumulators like Gen Zers for example. When would Roth make sense for an investor?

Giles: Right. So, Roth is a great option if your taxable income is low, and you think that you're going to maybe in the future earn a little bit more and it's also great if you're multitasking. So, for a Roth IRA, one of the biggest benefits is that you can actually withdraw money for any reason. You don't have to wait until retirement, and you won't pay a penalty because any money that goes into a Roth account has already been taxed and so you're really not confined to using it for retirement like you would be a traditional account. And so, basically, if you think, okay, I'm going to earn more money in the future or I want to multitask now, Roth is a great option.

Hampton: Well, let's move to the next stage, mid-career accumulation. That would include millennials like myself. Why can this phase be more complicated for people?

Giles: Because life is complicated. So first and foremost, you're in your kind of peak earning stage and that in itself can be complicated. Maybe you've moved jobs a couple of times, you've got multiple 401(k)s floating around. And then at this stage too, you're in your 40s and 50s potentially and maybe you have kids that you're thinking about funding their education. Maybe you have aging parents. There's just a lot more moving parts in your life and in your finances and that can be complicated to manage.

Hampton: As the young people would say, life be lifeing. So, can you break down what financial priorities someone in this phase should have?

Giles: Yeah, absolutely. So, some of these are the same. You want to keep developing your personal skills. Maybe you want to reach that next stage in your earnings and so the way to do that is more education for example. Next, maybe you want to balance, if you have kids, funding their education with your other goals like retirement. It's not just one or the other. You got to try to do both. Then you want to make sure you have the right insurance to make sure that everything is covered, especially if you've got dependents and to make sure that you still have and probably have a bigger emergency fund, because again, you've got a lot of things going on. Then you also want to combat lifestyle creep and up your savings. That can happen as you start to earn more. And then you also want to think about retirement and potentially open additional accounts if you've already maxed out your contributions to those retirement accounts.

And then when it comes to the portfolio, this is when you want to start to de-risk a little bit. You've accumulated. You want to make sure that you're not going to take on too much risk and lose what you have. But again, you still got time until retirement. And then lastly, you don't want to assume that a larger portfolio means it's got to be complicated. Even if you have multiple accounts, your holdings can actually be the same across all of them. And then again, things are complicated. So, consider working with a financial advisor. Maybe it's for you, maybe it's not, but it's time to think about it.

Hampton: Well, great news to everyone listening and watching. Margaret is going to come back to discuss the final two life stages. So, you want to make sure you check your feeds. Thank you, Margaret, for introducing us to life-stage investing.

Giles: Of course. Happy to be here.

Hampton: How much gain would you be willing to give up in exchange for some peace of mind? Some investors are making this trade-off for some predictability. What should you know before adding covered call and similar ETFs to your portfolio? Brian Armour is the director of Passive Strategies Research for North America for Morningstar Research Services. He's also the editor of Morningstar's ETF Investor Newsletter. Thanks for being here, Brian.

Byran Armour: Thanks for having me.

Hampton: So you're moderating a panel about option-based funds at the Morningstar Investment Conference in June. Can you explain what covered call and defined outcome ETFs, aka Buffer ETFs, are and how do they work?

Armour: Yeah, definitely. So both incorporate options in their strategy, but the similarities end there. So for a covered call ETF, you basically have exposure to an underlying stock position and then you sell a call option against it, which caps your upside a little bit, but gives you some income in the near term.

So with a defined outcome ETF, or Buffer ETF, you're adding a put spread on top of that. Which means you buy a put, add the money, and then you sell another put below that. And then for that little piece, maybe 10%, you don't partake in any of the losses of the index. So when stock market drops 10%, you won't lose anything. But after that, if it continues to go down, you will. And the way that you pay for that insurance, to some extent, is by selling the call in the same way that you would a covered call ETF.

Hampton: So that requires some monitoring.

Armour: Yes, absolutely.

Hampton: So what kind of investors are these strategies designed for?

Armour: I would say mostly pre-retirement or retirees that are looking for income or smoother returns. It really is a way to hedge some of the volatility of an all stock position. So in some sense, especially with the Buffer ETFs, it would be designed more like a balanced fund rather than a covered call, which is effectively just a way of almost like trading in some risk for income.

Hampton: Now, more money has been flowing into these funds. Why are investors adding them to their portfolios now?

Armour: Yeah, there are risks in the market. We're seeing a lot of concentration at the top of the S&P 500, for example. And people are worried that we might be in another bubble. To some extent, it could just be inertia from 2022 when people were looking for any source of yield that they could find and bonds weren't really an option in a rising interest rate environment. But it's a good way to take some of the risk off. But, obviously, that income you get doesn't cover much if stocks do go down. So it's something investors need to be cognizant of.

Hampton: Well, let's flip it. What are the downsides? Spell them out.

Armour: The main one's opportunity cost. So if the index goes up past the call options strike price, you don't get any of those gains. So for most investors, the reason why I said it's more for retirees, most investors, whether some of that volatility over a long term, you have decade, 5 years, 20 years, whatever it may be, you can handle some of that volatility, a drawdown, and still make the long-term higher returns. But with a retiree where you're withdrawing money, it becomes more important, the sequence of your returns. So you're willing to shed some of that return in order to cut down on volatility. So that's really where that trade-off comes from.

But in general, the opportunity cost is large. Stock market has what we call fat tails in the distribution of returns, which basically means there tend to be extreme performance on either side, negative or positive performance. And so when you have, in either case, a covered call ETF or a Buffer ETF, you sort of keep exposure to the bad tail to some extent and you give up exposure to the good tail.

Hampton: Brian, are there any tax concerns?

Armour: Yeah, for covered call ETFs there are. So because you're turning more of your total return into income that's taxed as ordinary income, which is at a higher tax rate than capital gains. So if you were to hold this for a longer term period, you'd be paying higher taxes than selling off capital gains. For Buffer funds, for the most part, there isn't as much income because you're offsetting the premium received from the call by paying for the puts. So there's not as much of a tax concern there.

Hampton: That's very visual. I got to ask you about fees. I feel like every time you come here, we talk about fees. Can you talk about what fees ETFs are costing investors hoping to shield themselves from volatility?

Armour: Yeah, so we always talk about fees because best predictors future success, right? The original Buffer ETFs were priced higher than what's currently on the market. So they were 75, base points at 1%, somewhere in there roughly were the fees. But since then we've seen new entrants. iShares has entered, JP Morgan, Parametric to name a few. And so fees have actually come down so you can get a reasonably good Buffer ETF for 50 basis points or less.

For covered call strategies it's more competitive. So the poster child is JP Morgan Equity Premium Income ETF, JEPI, which is a massive ETF but charges 35 basis points. We've seen some new entrants follow a similar strategy for a little bit less, so you could get 27, 28 basis points instead.

Hampton: Well, Brian, you and your panelists will go deeper into this topic at the Morningstar Investment Conference. Everyone listening and watching, check out the show notes for a link to register. Brian, thank you for coming back to the table.

Armour: Yeah. Thank you so much for having me.

Hampton: That wraps up this week’s episode. Thanks for listening. If you enjoy hearing market trends and analyst insights on our podcast, feel free to leave a five-star review on Apple Podcasts. It will help others find us. Thanks to senior video producer, Jake VanKersen, associate multimedia editor, Jessica Bebel, and editor Margaret Giles. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.

Covered Call and Buffer ETFs: Do the Pros Outweigh the Cons?

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