Volatility ebbs as $26bn pours into option-writing ETFs

Investors on the hunt for regular income have this year poured almost $26bn into exchange traded funds that sell options tied to stocks, inspiring a wave of copycats and raising questions about their effects on market volatility.

The funds, known as covered call ETFs, have surged in popularity to contain roughly $59bn in combined assets, up from only $3bn three years ago, according to Morningstar Direct. The number of ETFs in the category has nearly tripled in that time to about 60 in the US.

“The zeitgeist of the retail ETF investor has moved on to income-based products and options-based products,” said Dave Mazza, chief strategy officer at Roundhill Investments, which plans to launch three covered call ETFs in the near future after dropping a strategy focused on meme stocks.

ETFs are baskets of securities like mutual funds, but which trade on exchanges and enjoy preferential tax treatment in the US. Covered call ETFs sell options on underlying equity holdings to generate income in the form of premiums while also limiting the magnitude of gains and losses. Typically seen as a defensive strategy, they’ve enjoyed continued success in a year when US markets have boomed.

About half of this year’s new money into covered call ETFs has gone to the $30bn JPMorgan Equity Premium Income ETF (JEPI), an S&P 500 index-focused product that has grown to become the largest actively managed ETF. Another $13.7bn combined has gone into a second JPMorgan covered call product and a third from Global X, both focused on the Nasdaq Composite index.

The ETFs have grown so large that some analysts believe they are beginning to influence wider financial markets by dampening the widely followed Cboe Volatility Index, or Vix.

The Vix, popularly referred to as Wall Street’s “fear gauge,” is often used as a proxy for investor expectations of stock market swings. The index is calculated based on a complex formula tied to prices in options markets. It has crept lower throughout 2023 and is hovering near levels seen before the Covid-19 pandemic.

Alex Kosoglyadov, managing director for equity derivatives at Nomura, said funds systematically selling derivatives had helped reduce volatility by increasing the supply of call options and driving down their prices.

“We’ve seen a real influx of selling from a lot of these income funds,” Kosoglyadov said, adding that “a combination of a dovish macroeconomic backdrop and this systematic selling has really compressed volatility.”

Big asset managers including Morgan Stanley and Goldman Sachs and smaller firms such as REX Shares and Roundhill have laid the groundwork in recent months for covered call ETFs of their own.

But not everyone is so keen to join the trend.

Federated Hermes, a large active fund manager that started building ETF offerings within the past few years, is unlikely to compete in the covered call arena, chief investment officer Stephen Auth said. The firm’s experience with “doing stuff that’s hot at the moment” has not been good, he added.

“The money comes rolling in and then the whole thing collapses and the clients all want to shoot us,” he said. “It’s not worth it, so we try to stay with products that we think can add value to clients over a long period of time and not try to be too cute.”

Hamilton Reiner, JPMorgan Asset Management’s head of US equity derivatives and lead manager of its JEPI ETF, contends that income generation has “always been an important part of people’s portfolios.”

“Anything that’s not feasible as an investment and sounds too good to be true, maybe it’s more faddish,” Reiner said. “But traditional call overwriting is something that’s been going on for 50 years.”

Reiner encouraged newer covered call ETF issuers to be “slightly creative” when designing products and said he was “not really against them, but I’m also not rooting for them”.

“I think there’s enough money for many winners,” he said. “I think the space will continue to grow.”

Additional reporting by Nicholas Megaw in New York