Investor demand for income has fueled ETFs that use covered calls / call overwriting to pay large, frequent distributions. Israelov and Ndong’s “A ‘Devil’s Bargain’: When Generating Income Undermines Investment Returns” (2023) explains why headline yield can mislead: higher “income” can come with lower expected total return.
Key Takeaways:
- More option “income” can mean less expected return. Yield targeting often means selling lower strike calls (closer to the money). Lower strikes generally imply higher call delta—so the portfolio gives up more equity upside (less equity risk premium).
- Premium isn’t “income” like a dividend / coupon. Selling a call creates an obligation resolved at expiration / closeout. The authors show the call-selling leg has been loss-making on average despite upfront cash flow—so a portfolio can distribute a lot of cash while still dragging long-run total return.
- Evidence (~25 years, S&P 500 index options): higher yield targets → worse option P&L. Examples: in 1999 – 2023, ~6% “derivative yield” ≈ -0.60% / yr option P&L vs. ~12% ≈ -1.08% / yr; in 2011 – 2023, ≈ -3.1% / yr vs. -4.7% / yr.
- Higher “income” also worsens asymmetry. Covered calls cap upside while leaving meaningful downside (less the premium). As yield targets rise, upside participation falls faster than downside participation.
- Taxes can add friction. The paper notes covered-call implementations can be tax-inefficient versus simply holding the underlying and selling shares as needed, because derivatives may trigger taxable events along the way.
Connecting This to “Income ETFs” (e.g., QQQI and Similar Products):
- Many are marketed primarily on distribution rate, encouraging investors to equate distributions with long-term return—precisely the trap the paper warns about. QQQI discloses distributions have been classified largely as return of capital (ROC), and its Rule 19a‑1 notices have estimated very high ROC in certain months (e.g., ~99%); these are estimates, not final tax reporting.
Tax Treatment of ROC:
- While ROC is not taxed when received (if the investor’s basis > $0), it reduces the investor’s basis, which can increase taxable gain when shares are later sold / disposed. ROC is a tax classification, not a performance measure.
Conclusions:
- Covered-call “income” ETFs might fit when an investor intentionally wants equity with short-volatility exposure and understands the tradeoffs. As long-term core holdings (especially if investors equate distribution rate with “return”), they can amount to a “devil’s bargain.”
- Most individual investors should prioritize building a portfolio around low-cost passive index funds, focusing on total return, minimizing fees, and appropriate diversification, rather than anchoring on headline distribution rates.
Source: Roni Israelov and David Nze Ndong, “A ‘Devil’s Bargain’: When Generating Income Undermines Investment Returns,” October 26, 2023.