Why I just bought this high yield options income ETF

As a dividend investor, I am always on the lookout for investments that can generate sustainable income streams. I don’t always get it right (recent cutter-dividend Leggett & Platt instantly springs to mind), but for the most part, I made good calls. The only revenue generating tactic we have yet to find a sustainable solution for is covered calls.

The Amplify CWP Enhanced Dividend Income ETF (DIVO 1.25%) can change that.

What is a covered call?

Before we get into the details of the Amplify CWP Enhanced Dividend Income ETF and why I like it enough to buy, we need to talk about covered calls.

There are different ways to generate income from investments. The one I prefer the most is the dividend collection, which is as simple as it gets. Buy stock in a (hopefully) good company that distributes some of its profits to cash investors through regular dividend payments. Then, as a shareholder, you can simply sit back and collect those checks.

Image source: Getty Images.

You have to keep an eye on the companies you own, of course, but as long as the company is operating at a decent, if not high, level, investors can be pretty confident that the dividends will keep coming.

Another option that can be layered on top of the dividend approach is selling covered calls. Basically, this involves selling someone the right (ie, an option), but not the obligation, to buy your stock at a predetermined price at some point in the future. You will receive a fee (called a premium) for selling that right, but you must be prepared to sell the stock if the option is exercised or buy back the call option to close the position. This obviously limits your potential for the stock to go up — if it goes up enough to make the option profitable to exercise, the holder of that option will exercise it.

If the option is not exercised, you keep the premium and your stock. This is the income in your pocket. The problem for me is that I actually like the companies I own stock in and wouldn’t want to be forced to sell them. (I spend mode too much time to pick them in the first place!) So my foray into selling covered calls was short. But the appeal of the income that selling covered calls can generate has always stuck in my mind. This is the case with exchange-traded funds (ETFs) such as the Amplify CWP Enhanced Dividend Income ETF and Global X S&P 500 Covered Call ETF (XYLD 0.19%) Enter.

How the Amplify CWP Enhanced Dividend Income ETF conquered me

There are different ways to use covered calls and I have chosen the examples that I will use. However, the two extremes here are a neat portfolio of strategically selling covered calls (the approach taken by the Amplify ETF) versus tracking an index and writing covered calls on that index (which is what the Global X ETF does).

The fly in the ointment is that very often covered call ETFs push the limits on returns in an attempt to attract investors. The yield on the Global X S&P 500 Covered Call ETF is 9.2%. But think about that return for a second: It’s almost as high as the roughly 10% average return expected of S&P 500 investors over time. Chasing returns at that level doesn’t sound like a sustainable strategy – and it may not be.

XYLD data by YCharts.

As the chart above shows, the Global X ETF has declined in value over the past five years. If you look at its total return (which is included in the chart below), which assumes dividend reinvestment, its performance looks much better. But I invest in an optional income ETF with the express purpose of collecting and using the dividends. I’m not sure who would invest in an optional income ETF for any other reason.

This is where things get problematic. A falling price means there is less capital in the ETF to invest. Less capital means a smaller portfolio to write covered calls on. A shrinking portfolio of covered calls means less revenue can be generated. This is a downward spiral that tells me I cannot trust the Global X S&P 500 Covered Call ETF to provide a reliable income stream.

But look at that chart again, this time paying attention to the Amplify CWP Enhanced Dividend Income ETF. The value of that ETF has increased over the past five years.

XYLD data by YCharts.

A rising value means there is a larger portfolio of assets to write covered calls on. That means there is a chance to earn more income over time. That makes it an easy win in my mind.

But there is a trade-off. The Amplify ETF’s dividend yield is “only” 4.4%. The ETF balances capital appreciation with options income because it appears to provide a reliable income stream over time. And it seems to be the winning strategy. Notice that the Amplify ETF’s share price gains have been nearly as large as the Global X ETF’s total return over the past five years.

I’m giving the Amplify CWP Enhanced Dividend Income ETF a shot

To be fair, I’m not jumping in here with both feet. I just bought 100 shares of the Amplify CWP Enhanced Dividend Income ETF so I have a reason to watch it more closely. But I buy the story. Its managers pick a portfolio of dividend stocks they like and then strategically sell covered calls. This is what I would do if I sold covered calls. Its expense ratio of 0.56% is a little steep for an ETF, but given the active covered call strategy, I’m not too concerned about it. (Investment managers in this case are actually doing something to earn this money.)

However, the bigger story here is that dividend-loving investors like me need to be careful when looking at hedged call funds of any kind. If dividend yields are too high, the covered call strategy may not be sustainable. And if that’s the case, you could recoup your own shrinking capital with each dividend payment. Not a good deal.

I’m hoping the Amplify CWP Enhanced Dividend Income ETF will prove to me that a well-executed options income strategy can produce both a sustainable income stream and capital appreciation. If history is any guide, I think it will be.