Born out of the low-interest-rate era and during a time when stock market volatility left some investors nervous, so-called buffer and covered-call ETFs offer a way for skittish investors to stay in the market or get monthly income. These strategies now have close to $300 billion in assets, from near zero in 2020, according to data from Morningstar and Baird Strategas.
But there's no free lunch in markets. Buffer and covered-call ETFs sell call options, which give buyers the right to purchase an underlying asset at a set price and time. The ETFs give up some upside to buy downside protection or fund regular payouts, or distributions, so they lag behind broader markets when there are strong rallies. They're complex and price opaque, and some buyers may be taking more risk than they realize. Some narrowly focused ETFs, such as single-stock ETFs, are prone to wild swings in returns -- sometimes over just a few days.
Buffer ETFs
Buffer ETFs are the least risky of these products. They use options to provide partial downside protection, thus the term "buffer," in exchange for a cap on gains over a fixed period. The most popular ones protect buyers from the first 10% of losses of a benchmark, such as the S&P 500 index. New ones are released monthly, with varying levels of downside protection, so there can be dozens available at the same time.
Financial pros call buffer funds a real innovation for the risk-averse. Scott Opsal, director of research at the Leuthold Group, says using the proceeds from selling call options to buy some downside protection is a legitimate trade-off. "You get more upside than a bond, and if the market wobbles, you can ignore it. That's a true behavior changer for risk-averse investors," he says.
Yet investors may also still lose money if markets fall below the buffer level, warns Nate Geraci, president of NovaDius Wealth Management. Also, investors who buy these at a midpoint during the fixed period might find that their cap and buffer levels are different from what's advertised.
Covered-Call ETFs
Covered-call ETFs are somewhat more risky. They sell call options to give investors an income stream today at the expense of letting share price grow and compound over time to create a bigger investment.
Their selling points are attractive distribution rates, such as the 8% offered by the $45 billion JPMorgan Equity Premium Income ETF, the largest of these funds by assets.
The strategies work best in choppy, range-bound markets where there's little price appreciation but meaningful volatility, says Todd Sohn, chief ETF strategist at Baird Strategas. Options are priced partially on implied volatility, which reflects the options market's expectation of how far and how fast an underlying security will move over a specific time frame. Larger-than-expected market swings tend to fatten premiums and increase income.
For retirees who have ridden the stock bull market of the past few decades, using broad-based covered-call strategies to tap income makes sense, Sohn says. In the past few years, broad-based options-income ETFs have delivered more yield and were less volatile than long-dated bond ETFs, which tumbled in value during the sharp rise in interest rates.
Investors should be aware that if the benchmark asset falls, these ETFs will also fall, albeit slightly less than the underlying asset because of the yield cushion. They also don't rebound in line with benchmark gains because the upside was sold away.
Over time, the net asset value and price return can lag behind the benchmark, a common criticism of these funds. For example, Equity Income's three-year annualized return is 10.7% versus the S&P 500's three-year annualized return of 22.8%.
Hamilton Reiner, head of U.S. equity derivatives at J.P. Morgan Equity Asset Management, says in years like 2026, when there's a strong bull market, the JPMorgan Equity Income ETF lags behind. It won't outperform the index over a market cycle, but he expects it to have better risk-adjusted returns, since it is designed to be less volatile.
Investors should look at the strategy on a total-return basis, including income, and not just at price or net asset value. For Equity Income, Reiner says that over the past three years, distributions have been about 8% a year, with the 2% to 3% remaining being price appreciation.
Single-Stock and Non-Equity Income Strategies
The success of broad-based option-income ETFs have spawned other categories, including ones based on single stocks, gold, and Bitcoin. These are riskier because they aren't diversified, and are often more volatile than a broad index. But since options become more valuable as volatility increases, these ETFs can offer high payouts.
"Be cautious or extremely cautious of those types of things," says Dan Sotiroff, associate director of manager research at Morningstar.
The largest single-stock income ETF by assets is the $1.3 billion YieldMax NVDA Option Income Strategy. This ETF uses call spreads -- that is, it sells a call on Nvidia stock to collect the options premium for income, and buys a higher-priced call, which preserves more upside during sharp rallies than traditional covered-call ETFs. A year ago, it also changed its income payout to every week from monthly.
The fund holds a mix of U.S. Treasuries, plus monthly and weekly options on Nvidia stock, but not the stock itself. The weekly options can react more sharply to stock moves than longer-dated options, even though the stock isn't more volatile. The payout is more variable since the strategy resets every week. As of Oct. 15, the listed distribution was 33%.
Some YieldMax ETFs have much higher distribution rates, such as the $1.1 billion YieldMax MSTR Option Income Strategy, which buys and sells options on Strategy stock and had an 82.9% distribution rate as of Oct. 15.
Mike Khouw, a strategist at YieldMax, says when looking at ETFs with high distributions, investors should consider the distribution rate against a reference asset's realistic rate of return to judge whether they think it is too risky. "If you see a very high yield in bonds, that tells you that there's probably something a little bit riskier there," he says.
These are for high-conviction, active traders who prize cash flow over total return and expect a stock to trade range-bound for a short time frame.
Autocallable ETFs
There's a new category of complex options-income strategy ETFs that also offers high payouts. Generally, autocallable ETFs ladder a series of options tied to equity markets, either an index like the S&P 500 or a single stock, created to give stable payouts as long as the options stay above a customized downside barrier, but investors give up any price gains.
The barriers are often set very low, such as a 40% loss. However, if the barrier is broken, investors lose everything. Some ETFs, such as the $1.4 billion Calamos Autocallable Income, the first of these to launch a year ago, diversify by laddering more than 50 individual options to reduce that risk. As of Sept. 30, it had a monthly 14.3% distribution rate.
Option-focused ETFs became popular when bond yields were low a few years ago and picked up steam during 2022's bond rout, when bond funds lost money. Now, with the 10-year U.S. Treasury yielding 5.1% and investment-grade bonds yielding 5.8%, income investors have more options.
Geraci says with bonds yielding more and providing their traditional ballast to stocks, investors could simplify their portfolios by owning lower-cost stock ETFs and manage the equity risk with high-quality bonds or other assets, rather than buying these option-strategy ETFs and paying their higher fees.
"It's easy to point to 2022 as a reason to avoid bonds, but investors have to remember, that was a historically bad year for fixed income. I don't believe investors should approach portfolio construction by simply focusing on outlier years," he says.
Reiner says the higher bond yields create competition across asset classes for investors' dollars, but he still sees room for options strategies in portfolios.
"At their current levels, bonds are attractive," Reiner says. But he argues that options-based ETFs provide income without credit spread or duration risk -- both of which can bite bondholders -- and can serve as a complement to stocks and bonds, even though they limit potential upside.
With all these ETFs, distribution rates are sometimes referred to as yields, but the financial experts warn that these payouts aren't like traditional bond payouts where coupons are fixed. Distribution rates aren't guaranteed returns and shouldn't be equated with a bond yield.
Reiner also stresses that these aren't bond replacements and don't play that role. "Bonds are bonds. Stocks are stocks. This is somewhere in between," he says. "These may help you create a different source of return from a well-balanced portfolio."
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