Covered Calls: What People (Still) Get Wrong https://t.co/FxCgelKDJD

https://t.co/uWE7aLVf0V

https://t.co/iOjLoqLbmR

Psychological income/mental accounting arguments aside, if there's a case for covered calls for long-term investors, I have not been able to find it. (Yes, I am aware of the volatility risk premium.)

On average, mixing 26% cash with the underlying equities gives the same result as holding covered calls. Keep in mind that you're also paying higher fees and potentially introducing tax inefficiency to effectively add a large cash position to the portfolio.

Covered calls underperform. On average, they leave 26% less wealth after 10 years, holding spending constant. Since covered calls reduce exposure to the underlying, I looked at the cash allocations required for the ending wealth of the two scenarios to be equal.

The common response is that covered call investors care about income, not total returns. I took 5 covered funds (4 shown here) and compared spending their distributions to investing in their underlying equities while spending the exact same dollar amount over 10 years.

Total returns for covered call funds with reasonably long histories typically show consistent underperformance. I'd love to see an example of a covered call fund with 10+ years of history that has outperformed its underlying equity. I have not found one yet.

Mean reversion (negative autocorrelation) makes stock returns a little less risky at long horizons than they would be if returns were completely random. Covered calls reduce expected returns by shorting exposure to the underlying, and they increase risk for long-term investors.

Stock returns are volatile. Mechanically missing high returns on good days has serious long-term effects, but the asymmetric nature of covered calls makes them even worse. They offer minimal downside protection and limit upside, destroying any mean reversion in stock returns.

While the distributions may feel like "income", selling the call is only the first step in the trade. The fund has sold the right to buy the underlying stock at the strike price, putting a cap on upside returns with potentially detrimental effects on total returns.

Covered call funds sell call options on their underlying positions. Selling a call option means selling the right to buy the underlying stock at a predetermined price, called the strike price, in exchange for a premium. Those premiums are distributed as income to investors.

The idea that covered call funds create "passive income" is financial bullshit. Covered calls mechanically lower expected returns, consistently underperform their underlying equities, and increase risk for long-term investors. They even underperform when income is the goal. ↓

Here's a short summary in the Globe and Mail.

We also looked at Edmonton, Ottawa, Winnipeg, Quebec City, Hamilton, Kitchener-Waterloo, Victoria, and Halifax. Some results are here, and the rest are available in our new paper https://t.co/bhB0En4X0f

Calgary is interesting. Prices were low in 2005, allowing owners to lock in small mortgages, then prices (and rents) almost immediately shot up. This made the cash flow costs of owning for the full period lower than renting. The ending renter-to-owner net worth ratio is 0.37.

Vancouver apartment price growth was among the highest in the sample while rent growth was the highest in the sample. The cash flow costs of renting were also high relative to owning. This combination resulted in an ending renter-to-owner wealth ratio is 0.71.

Montreal apartments appreciated at a relatively modest rate and renters had much lower cash flow costs than owners. Renters came out ahead by a wide margin, with an ending renter-to-owner wealth ratio of 1.48.

Toronto apartments experienced high price and rent growth throughout our sample. The cash flow costs of renting were well-below those of owning, allowing renters to save and invest. Renters came out ahead with an ending renter-to-owner wealth ratio of 1.05.

We measure ending outcomes as the ratio of renter wealth to owner wealth. In seven of twelve cities, renter wealth exceeds owner wealth at the end of the 20-year period. A figure above 1 indicates that renters came out ahead financially. On average, the ending ratio is 0.99.