Covered Call ETFs: High Yield Mirage or Strategic Opportunity?

The allure of high income in a low-yield world has driven investors to covered call ETFs, which promise steady payouts by selling call options on their underlying equity holdings. Yet beneath the surface of these products lies a complex web of tax consequences, structural limitations, and underperformance that demands scrutiny. For investors, the question isn't whether covered call ETFs can deliver income—they can—but whether the trade-offs justify their place in a portfolio. This article dissects the risks of return of capital (ROC) distributions, exposes performance shortcomings, and offers a roadmap for navigating these funds with discipline.

The Return of Capital Deception

Covered call ETFs like the NEOS S&P 500 High Income ETF (SPYI) and ProShares S&P 500 High Income ETF (SPYD) use ROC distributions to defer taxes, but this comes at a hidden cost. In 2024, 93.91% of SPYI's distributions were classified as ROC, a figure rising to 96% by early 2025. For QQQI, the Nasdaq-100 focused counterpart, 99% of distributions were ROC in May 2025. While this reduces immediate tax liability, it erodes the investor's cost basis. Over time, this creates a deferred tax liability: selling shares later could trigger higher capital gains taxes.

The tax complexity deepens further. Unlike capital gains, the income from options trades in these ETFs is taxed as ordinary income under Section 1256 rules. This hybrid treatment—60% long-term, 40% short-term—adds confusion, but the broader issue is the tax cost ratio, which measures how much performance is lost to taxes. One analysis found this ratio for covered call ETFs is seven times higher than for plain index ETFs like VOO.

Performance Under the Microscope

The numbers tell a stark story. Since their inceptions, SPYI and XYLD (another covered call ETF) have trailed the S&P 500 by over 600 basis points, with gaps widening during bull markets. In 2023 and 2024, these ETFs struggled as equities rallied, sacrificing upside to preserve income. While they offered downside protection during the 2022 downturn, their total return since 2020 lags the S&P 500 by 32%, per Global X's analysis.

The problem isn't just underperformance—it's structural. Selling call options inherently caps upside potential while requiring volatile market conditions to justify premiums. In 2025, declining volatility reduced premium collection, squeezing income even as interest rates hovered near 5.5%. This creates a vicious cycle: when equity gains fall short of payouts, funds must dip into principal (via ROC) to maintain distributions.

The Cost Drag: Fees and Front-Running Risks

High expense ratios exacerbate the challenges. While VOO charges 0.03%, SPYI and QQQI levy 0.29% or more, eating into returns. Worse, fixed-schedule option strategies—common in these ETFs—invite front-running. Traders anticipating option expirations can exploit pricing inefficiencies, further diluting returns.

Market Cycle Considerations

Covered call ETFs thrive in specific environments:
1. High volatility: Boosts option premiums (e.g., MLPD's 2.71% premium in February 2025 amid sector-specific risks).
2. Sideways markets: Avoids the drag of missed upside in rallies.

But they falter in prolonged bull markets or low-volatility expansions. For example, in 2023, the S&P 500 rose 14%, but SPYI's total return was just 19.04%—a gap widening as costs and ROC mechanics take their toll.

Investment Advice: Proceed with Nuance

1. Avoid core allocations: These ETFs are not core holdings. Their underperformance and tax drag make them inferior to low-cost index funds for long-term growth.
2. Tax-aware investors only: Use them in tax-advantaged accounts (e.g., IRAs) to mitigate the ROC's impact.
3. Sector-specific opportunities: Consider niche ETFs like MLPD (if data exists) during volatile periods, but verify distribution composition first.
4. Monitor ROC percentages: If ROC exceeds total returns over years, the fund is eroding capital—exit.

Final Verdict

Covered call ETFs are neither a surefire income play nor a complete failure. They offer downside protection in turbulent markets and tax efficiency for some investors—but these benefits come with trade-offs that demand careful evaluation. For most portfolios, the high yield is a mirage: the tax costs, underperformance, and structural limitations outweigh the short-term income boost. Use them selectively, and always pair with low-cost equity exposure to balance risk.

In the end, the key lesson is clear: yield is not free. When evaluating covered call ETFs, ask: Is the income worth the drag on growth, the tax complexity, and the risk of capital erosion? For most investors, the answer will be no—unless the market cycle aligns precisely with their strategy.