Global X launches new sector covered call ETFs

How the new sector covered call ETFs work

All three ETFs aim to replicate the stocks held in the SPDR Select Sector indexes, each of which tracks a specific market-cap weighted sector represented in the S&P 500. In this case, the new Global X ETFs will track stocks from the financials, healthcare, and information technology Select Sectors.

Being able to break down covered call ETFs into sectors is interesting. Historically, each of these sectors has performed differently under various economic conditions. For example, healthcare tends to outperform in recessions and technology tends to outperform when interest rates fall.

Putting a covered call overlay over the sector allows sector investors to harness volatility for increased income potential, or vice-versa allows income investors to tilt towards a sector of their choice. Either way, investors get increased versatility and another tool in their toolbox. 

All of the new sector ETFs actually track a new index, the Cboe S&P (insert sector) Select Sector Half BuyWrite Index.This means that covered calls are only sold on 50% of the ETF's underlying holdings. The calls sold are at-the-money with a month until expiry.

I like this approach because it doesn't excessively cap the ETF's upside potential. Some covered call ETFs sell calls on 100% of the ETF's underlying assets. While this maximizes the premium and thus income potential, it reduces total returns drastically. 

Use cases and risks

I think these ETFs are best suited for investors who are implementing a sector rotation strategy or tilt in their portfolio, but desire lower volatility and more consistent income potential while still participating in some upside return. I think it's a better way to define a target level of risk and return. 

The big benefit here is convenience. Buying one of these ETFs and paying Global X a 0.60% expense ratio every year is probably less than the hassle of buying individual Select Sector ETFs yourself and manually selling and rolling options. 

Global X's portfolio team will do it in a systematic manner, which will likely outperform retail investors trying to select the right strikes and expiry dates, calculate options delta and implied volatility, and minimize bid-ask spreads. There's less room for error and more economy of scale.

The ETFs will also likely have lower downside risk compared to their vanilla sector ETF counterparts. This is because the premium received from selling calls can help offset some losses. It's not the most effective hedge, but covered call ETFs have displayed lower drawdowns so far this year.

As with all covered call ETFs, the main risk is underperformance during bull markets. During these conditions, the sold options will likely expire in-the-money, causing the underlying shares to get called away at the strike, capping total returns. 

This is to be expected and should be accounted for in your investment objectives before you consider buying a covered call ETF. If consistent income isn’t a need, then these ETFs might not be ideal for you. Regardless, the new Global X ETFs certainly have their niche and I expect strong inflows to pour in.

Please note this article is for information purposes only and does not constitute investment advice.