Covered call ETFs challenge traditional 60/40 portfolio construction

Covered call ETFs are evolving from niche income-generating vehicles into strategic portfolio-construction tools capable of replacing both bond and equity allocations, according to a new paper from Global X.

Many ETF structures now are essentially giving investors structured product-like returns without needing to buy a bespoke note - Robert Scrudato

In Rewriting the Portfolio Playbook with Covered Call ETFs, Robert Scrudato, vice president and product specialist at Global X, argues that the rapid expansion of options-based ETF strategies is giving investors new ways to generate income from market volatility while managing risk exposures traditionally addressed through fixed income.

At the heart of the strategy is the covered call trade, where an investor holds an underlying asset while selling call options against that position. In exchange for capping a portion of future upside, investors receive option premiums that can be distributed as income.

According to the paper, the economic rationale is supported by the volatility risk premium, whereby implied volatility embedded in option prices tends to exceed realised volatility over time, creating opportunities for systematic option sellers to harvest premium income.

"The ETF structure has helped democratise access to these strategies," Scrudato (pictured) notes, highlighting how fund vehicles have removed many of the operational, capital and regulatory hurdles that previously limited covered call implementation to institutional investors.

The report argues that covered call ETFs should no longer be viewed as a single category. Instead, different option-writing approaches can serve distinct roles within portfolios.

Strategies that write call options against 100% of their holdings maximise premium generation but sacrifice most upside participation. These products can increasingly be viewed as alternatives to traditional fixed-income allocations, particularly when option income exceeds bond yields. However, Scrudato noted that the trade-off between income and equity risk remains highly investor specific.

“It depends on the investor's specific risk appetite and income goal. You decide case by case how much equity risk you're willing to accept to hit a target income level.”

Partially covered approaches, meanwhile, seek a balance between income generation and capital appreciation. By writing options on only a portion of portfolio holdings, investors retain exposure to equity upside while still collecting premiums, making them more suitable as equity allocations.

The growth of the options market has also expanded the opportunity set for ETF issuers. US options trading volumes have more than doubled since 2020, while increasing liquidity in shorter-dated contracts has encouraged managers to adopt weekly option-writing strategies that seek to capture accelerated time decay.

Beyond options premium

Global X points to the emergence of actively managed covered call ETFs that target specific distribution levels rather than maximising option premiums. Such approaches dynamically adjust portfolio coverage based on prevailing volatility conditions, seeking to preserve net asset value while maintaining sustainable distributions.

While income remains the primary attraction, Scrudato believes investors must look beyond headline yields when evaluating these products.

“There is still a significant education curve, but conversations have begun to move beyond the fundamentals and toward more nuanced considerations like the income source, its potential impact on net asset value, and tax considerations.”

According to Scrudato, investors should focus not only on distribution rates but also on where income is generated, the potential impact on net asset value and the tax treatment of distributions, including instances where payouts may be classified as return of capital.

The paper concludes that the growing diversity of covered call ETF structures requires investors to assess factors such as coverage ratios, option tenors, underlying assets and distribution methodologies rather than relying solely on yield metrics.

From a portfolio construction perspective, Scrudato sees covered call ETFs primarily as dedicated income sleeves rather than core growth allocations.

“These are strategies that can represent one of several income sources that an investor can incorporate into their portfolio. A big part of the conversation is making sure investors understand the role of the strategy in the broader portfolio, not just the yield.”

As issuers expand the range of reference assets to include equities, fixed income, cryptocurrencies and other ETFs, covered call strategies are becoming increasingly integrated into modern portfolio construction frameworks. Scrudato expects assets under management to continue growing, although he believes investors will become more selective as the market matures and product differentiation becomes increasingly important.

"We think time and track record through ebbs and flows will separate the more responsible structures from the rest," he said.

The rise of options-based income ETFs has also revived comparisons with traditional structured products. Scrudato sees the relationship as both competitive and complementary.

"Many ETF structures now are essentially giving investors structured product-like returns without needing to buy a bespoke note," he said. "But traditional structured products can still offer levels of customisation and defined maturities that ETFs cannot fully replicate."

According to Scrudato, the traditional 60/40 portfolio was designed for a different market environment, and covered call ETFs represent one of the most significant additions to investors' toolkit in recent years.

Click the link to read the GlobalX Rewriting the Portfolio Playbook with Covered Call ETFs white paper.

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