RYLD And Other Covered Call ETFs Outperformed In 2022, What About 2023? (NYSEARCA:RYLD)

Author’s note: This article was released to CEF/ETF Income Laboratory members on December 9th.

Covered call funds are extremely popular investments in retirement circles, and with good reason. Covered call funds offer investors strong dividend yields, some rising to double-digits, albeit low potential capital gains. Covered call funds have seen very strong performance these past few months, with most funds outperforming their benchmark in 2022, and by very healthy margins.

Owing to the popularity, yields, and strong recent performance of these funds, I thought an article analyzing and explaining their performance for 2022 would be of use and interest to readers.

Covered call funds have significantly reduced potential capital gains, higher dividends, and equal downside potential.

Equities went down in 2022, so both covered call funds and normal equity funds were down. Reduced potential capital gains were a moot point: equities went down, so there was nothing there to reduce.

Dividends were particularly strong in 2022, as option premiums spiked due to heightened volatility. Covered call funds benefitted from higher option premiums, while normal equity funds did not.

If equities continue to drift downward and volatility remains high, covered call funds should continue to outperform.

In my opinion, equity volatility will likely remain elevated in 2023, as economic conditions will likely remain volatile. On the other hand, equity prices will likely increase, due to cheaper valuations, improved economic fundamentals, and as stocks mostly go up. Under these conditions, I do not expect covered call funds to significantly outperform relative to their indexes moving forward.

As a final point, I’ll be focusing on the Global X Russell 2000 Covered Call ETF (NYSEARCA:RYLD) in this article, but everything here should apply to all covered call funds in more or less equal measure.

Covered Calls Strategy Overview

To understand why RYLD outperformed in 2022, we must first understand what the fund’s strategy is, and how it works. Feel free to skip this part if you already know all about covered call funds and how they work.

RYLD is an index ETF tracking the Cboe Russell 2000 BuyWrite Index.

In technical terms, RYLD invests in the Vanguard Russell 2000 ETF (VTWO) and in the individual components of the Russell 2000 index. RYLD sells covered calls on the Russell 2000 index, for the entirety of its holdings. Calls have a maturity date of one month, and a strike price higher than, but closest to, current market prices. Calls are rolled over the third Friday of each month.

Let’s go through what the above entails. For simplicity’s sake, I’ll be assuming that RYLD invests in the Russell 2000 index directly, and that the fund was created on January 20th, the third Friday of January.

RLYD invested in the Russell 2000 index on January 20th at a price of $1846 per share.

RLYD then sold call options on said index, at the $1850 strike price, for $47.20 in premiums per option.

Figures as per CBOE.

As an aside, I’ve been covering these funds for a while and it seems that strike prices are now much closer to market prices than in the past.

Selling these covered calls gave RYLD’s counterparty the right, but not the obligation, to buy the Russell 2000 index at maturity (third Friday of February) for the predetermined strike price ($1850).

Selling covered calls has several important, well-known, implications for a fund and its investor.

Selling covered calls caps upside potential to the predetermined strike price. RYLD will see comparable capital gains to the Russell 2000 index as the index rises to $1850, but will zero further capital gains from further increases. In effect, RYLD’s capital gains are capped when the Russell 2000 reaches $1850.

Selling covered calls generates significant premiums, or cash. RYLD received $47 in premiums per option sold. RYLD distributes said premiums to shareholders as dividends, to a cap of 12.0% per year. Excess premiums are retained within RYLD, used to buy more Russell 2000. Cap was reached sometime in 2022, with the fund retaining a significant portion of their premiums since then. By my calculations, the fund would distribute around $18.50 per option as dividends to shareholders, equivalent to around $0.19 per share.

Selling covered calls has no impact on potential capital losses. If the Russell 2000 goes down in price, RYLD’s share price should decrease too.

From the above, it seems clear that RYLD’s covered call strategy trades away most potential capital gains for increased dividends, while downside potential remains unchanged.

RYLD’s returns, especially its relative returns, are strongly impacted by these two factors. Higher premiums means higher dividends, boosting the fund’s absolute and relative returns (the Russell 2000 does not receive option premiums). Higher equity share prices means low, but positive, capital gains for RYLD, but much higher capital gains for the Russell 2000.

In absolute terms, RYLD benefits from both higher premiums and higher share prices.

In relative terms, RYLD benefits from higher premiums and lower share prices, which is exactly what happened during 2022.

Let’s have a closer look.

RYLD – 2022 Performance

RYLD sells call options. As with most securities, call options have prices, and these boomed during 2022, a significant benefit for the fund and its investors. To understand why prices increased, in might be easier to understand how these options work from the perspective of the buyer.

Call option buyers pay a relatively small premium in exchange for potential capital gains. In this particular case, option buyers paid RYLD $47.20 per option to buy Russell 2000 potential capital gains from $1850 onward. Presumably, these buyers are bulls, thinking the Russell is going to see gains in the coming weeks, and wish to profit from these through some cheap call options.

The premium these buyers are willing to pay for these options is dependent on many factors, but volatility is key. Investors are generally unwilling to pay large premiums when volatility is low, as the probability of large price movements and outsized capital gains is quite low too. Investors are generally willing to pay large premiums when volatility is high, due to a higher probability of large price movements and significant capital gains. Volatility is much higher since the onset of the coronavirus pandemic, leading to higher option prices.

Investors are also generally willing to pay large premiums after a significant selloff, as volatility tends to spike during these, and owing to the probability of a recovery and attendant capital gains. Call option buyers made a killing after March 2020, as stocks soared following the coronavirus selloff. Call option profits could be high after any selloff, so prices tend to be high too.

Due to the above, call option prices were very high during 2022, which meant RYLD generated a significant amount of premiums. As these are distributed to shareholders, the fund should have seen strong, growing yields. That was indeed the case, although dividends were very volatile.

RYLD’s strong, growing yield directly increases total shareholder returns and could, potentially, lead to significant, market-beating returns. RYLD’s strong, growing yield allowed the fund to outperform relative to its index during 2022, but RYLD still saw losses, as stock market losses/lower equity share prices outpaced its yield. So, the fund benefitted from higher option prices, but capital losses were sizable enough that the fund posted net losses.

Let’s summarize the above.

RYLD sells call option, and distributes the premiums to shareholders as dividends. Option prices were very high in 2022, which meant premiums and dividends were very high too, increasing returns and leading to outperformance.

RYLD should continue to benefit from high option prices as long as volatility remains high. In my opinion, volatility will likely remain high in 2023, due to volatile economic and industry conditions. Volatility might come down once economic conditions, especially inflation and interest rates, normalize, and industry sentiment improves. I also believe this is likely to occur, but it will take a while, and conditions will likely remain volatile for longer too.

As an aside, I’ve found that the impact of higher option prices to have had a very broad, positive impact on the fund’s performance and fundamentals. RYLD’s share price, yield, capital gains, capital losses, and total returns have all markedly improved since early 2020, at least vis a vis the Russell 2000.

RYLD’s outperformance in 2022 is also partly explained by weak Russell 2000 capital gains/share price declines. As mentioned previously, the index was down almost 23% during the year, so there were no net capital gains during the year.

Remember that RYLD’s capital gains are significantly reduced or capped, so the fund sees little benefit from higher equity prices, unlike most of its peers.

If equity prices had risen by a lot during 2022, RYLD would almost certainly have underperformed. Equity prices went down, so this was not an issue.

If equity prices had risen by a lot during parts of 2022, the fund would have seen significantly reduced capital gains during these, which might have led to underperformance. Equity prices did rise during parts of 2022, and the fund did see significantly reduced capital gains during these periods, but gains were infrequent and weak, so these were not significant issues for the fund.

As an example, RYLD saw below-average capital gains and total returns in Q4 2022, during which the Russell went up by 5.7%. Higher capital gains during said quarter might have led to underperformance for the year, but 5.7% in capital gains were simply too low for this.

Although the distinction between capital gains during the entire year versus parts of the year might seem unnecessary, I think it is important. RYLD sees comparable capital losses to the Russell 2000, but much weaker capital gains, so the fund sees weaker capital gains / higher capital losses from peak to trough. Depending on the magnitude and length of the cycle, the fund could see significant capital losses and underperformance during a cycle, from peak to trough.

As an example, RYLD significantly underperformed during 2020, in which equities saw significant, sharp losses followed by a strong, albeit slow, recovery. RYLD underperformed as it suffered 100% of the losses as stocks went down, but fewer of the gains as these recovered.

RYLD might have underperformed in 2022 if stocks had rallied more aggressively late in the year. They did not, so the fund outperformed.

RYLD should continue to benefit from these trends as long as equity capital gains remain weak and infrequent. In my opinion, equities should post stronger capital gains and returns moving forward, as economic and industry conditions normalize, and as bull markets are the most common market scenario. Stocks mostly go up, years like 2022 are somewhat uncommon.

Conclusion

RYLD outperformed in 2022 due to strong option prices and premiums, and weak equity capital gains. Insofar as these two trends continue, the fund should continue to outperform. In my opinion, strong option prices are likely to persist moving forward, but weak capital gains are not. Under these conditions, I do not expect RYLD to significantly outperform relative to its index moving forward.