Option-Based Income Funds: Pros and Cons
In recent years, option-based income funds have gained popularity among income-focused investors. These funds employ strategies such as covered call writing or put writing to generate income from options premiums. By using an underlying ETF, index, or even a single stock, they provide a unique way to enhance yield. Notably, single-stock option income ETFs, like TSLY, focus on options derived from a single stock, aiming to maximize income while maintaining exposure to the underlying asset. Using an underlying ETF, index, or even a single stock that’s highly volatile (thus high option premium), these funds often provide exceptionally high income yields. For instance, the trailing 12-month yield of the YieldMax TSLA Option Income Strategy ETF TSLY stands at an astounding 86.96%! These funds entice investors looking for high yield but come with their own set of risks and trade-offs.
Pros of Option-Based Income Funds
- Higher Income or Yield One of the most attractive features of option-based income funds is their potential to generate higher yields. By selling options, these funds collect premiums, which are distributed as income to investors. This can result in significantly higher payouts compared to traditional dividend-paying stocks or ETFs.
- Potentially Lower Downside Risk Some option-based strategies, like covered call writing, can provide a cushion against downside risk. The premium collected from selling calls acts as a buffer, potentially offsetting minor declines in the underlying asset’s price. However, it is essential to note that this does not guarantee protection in all market conditions.
Cons of Option-Based Income Funds
- Higher Expenses Option-based income funds often come with higher expense ratios compared to traditional ETFs. The active management required for executing options strategies, along with higher transaction costs, contributes to these elevated fees. For example:
- TSLY (YieldMax TSLA Option Income Strategy ETF): Expense Ratio of 0.99%, which is significantly higher than broad-market ETFs like SPY (S&P 500 ETF) with an expense ratio of around 0.09%.
- APLY (YieldMax AAPL Option Income Strategy ETF): Expense Ratio of 0.99%, reflecting the costs of managing single-stock option strategies.
- NVDY (YieldMax NVDA Option Income Strategy ETF): Expense Ratio of 0.99%, much higher than passive ETFs like QQQ, which tracks the Nasdaq-100 with an expense ratio of approximately 0.20%.
- Lower Total Returns While these funds offer high income, their total returns may lag the underlying assets over the long term. According to data from MyPlanIQ’s YieldMax ETF Comparison, YieldMax funds often underperform their respective underlying stocks in terms of total return. For example, as of 1/3/2025:
- TSLY: Over the last year, it generated a total return of 44%, compared to Tesla’s 72%.
- APLY: Delivered a total return of 17.6%, significantly trailing Apple’s 32.7%.
- NVDY: Achieved a total return of 133%, significantly underperforming NVIDIA’s robust 208% return. This underperformance arises because option strategies cap upside potential, limiting gains during strong market rallies.
- Taxable Income The income generated by option-based funds is typically taxed as ordinary income. For investors in higher tax brackets, this can significantly reduce the net yield compared to qualified dividends or capital gains from traditional investments.
Discussion: Balancing Yield with Trade-Offs
While the high yields offered by option-based income funds are appealing, the associated trade-offs warrant careful consideration. The high expense ratios can erode returns, particularly for long-term investors. Furthermore, the capped upside of these strategies may result in missed opportunities during bull markets, leaving investors with lower total returns compared to holding the underlying asset directly.
Tax efficiency is another critical concern. For investors in taxable accounts, the ordinary income classification of distributions can make these funds less attractive compared to investments offering qualified dividend income or long-term capital gains.
For single-stock option income ETFs, such as TSLY, the risks are magnified. Their reliance on a single underlying stock makes them particularly vulnerable to volatility and price declines. While the income may be enticing, these funds require a deeper understanding of the underlying stock’s performance and market dynamics.
A Better Approach: Total Return View
The total return based income approach emphasizes overall total returns—including both price appreciation and reinvested dividends—rather than relying solely on income-producing assets like bonds, dividend-paying stocks, or option-based income funds. In this approach, investors generate cash by selling shares from the underlying when income is needed.
While some investors might find the periodic selling of shares is a hassle, this can be mitigated by selling less frequently, such as quarterly or semi-annually instead of monthly. More importantly, this approach often delivers superior returns by avoiding the high expenses and capped upside potential associated with option-based income ETFs or similar methods. Additionally, it is more tax-efficient, as investors can sell shares held long-term, thereby classifying the income as long-term capital gains. This contrasts with option premiums, which are typically treated as short-term capital gains or taxed as ordinary income.
- Better Overall Returns Using a Total Return Approach
When utilizing a total return approach, where the focus is on the overall growth of the portfolio rather than relying solely on income-producing assets, empirical data suggests that this strategy may lead to better overall returns. For example, comparing YieldMax ETFs, which focus on using covered call strategies to generate income, to traditional income-based investing in dividend-producing assets shows that the total return approach often provides higher growth. YieldMax ETFs have shown that, despite generating income through option premiums, the long-term growth of the portfolio is not constrained by the need for consistent income streams from dividends or bonds. By selling shares to derive income when needed, investors can achieve greater flexibility and potential for higher returns as they are not limited to income produced by dividends or interest alone. This method leverages the overall growth of the portfolio, which can be particularly advantageous during periods of strong market performance. - Tax Efficiency: Long-Term Capital Gains vs. Option Income
Additionally, selling shares, especially those held for a longer period, can be more tax-efficient than relying on option premium income. When using the FIFO (First In, First Out) method for selling shares, long-term capital gains tax rates apply to assets that have been held for over a year. These rates are typically 0%, 15%, or 20%, depending on your income level, which is often more favorable than the tax rates on option income. On the other hand, option premiums from strategies like covered calls are generally taxed as ordinary income or short-term capital gains if the option expires within a year. This means option-based income can be subject to higher tax rates, particularly for higher-income earners. By selling longer-held shares and taking advantage of long-term capital gains tax rates, investors may reduce their overall tax burden, making this strategy more attractive in managing larger portfolios or when seeking to optimize after-tax returns.
Conclusions
Option-based income funds can be a valuable tool for income-focused investors, particularly in low-yield environments. However, their higher expenses, potential underperformance, and tax implications necessitate a cautious approach. Investors must weigh the trade-offs carefully, ensuring that these funds align with their broader investment goals and risk tolerance. For those willing to accept the limitations, these funds can provide a steady income stream but are best viewed as a complement, rather than a substitute, for traditional investment strategies.
See YieldMax ETFs Comparison for the latest and more complete return data.