Covered Call ETFs in Retirement Portfolios: Balancing Income and Risk

For retirees seeking to bolster income while mitigating market risks, covered call ETFs have emerged as a compelling yet contentious tool. These funds, which generate income by selling call options on underlying assets, offer yields that often dwarf those of traditional dividend-paying equities or bonds. However, their utility in retirement portfolios hinges on a nuanced understanding of strategic allocation and risk-adjusted returns.

The Allure of Income, the Cost of Growth

Covered call ETFs, such as the Global X S&P 500 Covered Call ETF (XYLD) and the NEOS S&P 500 High Income ETF (SPYI), have attracted retirees with yields exceeding 13% in recent years. By selling call options, these funds collect premiums that enhance income but at the expense of capping upside potential. For instance, XYLD has trailed the S&P 500 by over 600 basis points since inception, underscoring the trade-off between income generation and long-term capital appreciation. Morningstar analyst Daniel Sotiroff cautions that such strategies are ill-suited for investors in the accumulation phase, as the forgone gains during bull markets can erode returns over time.

Downside Protection: A Misleading Promise?

While covered call ETFs are often marketed as a hedge against market downturns, empirical evidence suggests their downside protection is limited. During the 2022 bear market, funds like QYLD (Nasdaq 100) and XYLD failed to outperform broad indices during recovery periods, despite their high yields. A 2025 analysis revealed that these ETFs exhibited crash risk nearly equivalent to the S&P 500, with a DUVOLT measure of -0.21, indicating minimal diversification benefits during volatility.

ProShares' alternative strategies using daily call options claim better risk mitigation, but they diverge from traditional monthly covered call models.

Strategic Allocation: Tax Efficiency and Portfolio Balance

To maximize the benefits of covered call ETFs, strategic allocation is critical. Financial advisors often recommend limiting these funds to 33% or less of a retirement portfolio to avoid overexposure to capped growth and tax inefficiencies. Distributions from covered call ETFs are frequently taxed as ordinary income, reducing their appeal in taxable accounts. Instead, allocating these ETFs to tax-sheltered accounts-such as IRAs-can mitigate this drawback.

A balanced approach might pair covered call ETFs with traditional assets like bonds and dividend equities. For example, a 75/25 stock/bond allocation could allocate a portion of the equity side to covered call ETFs while the remainder is invested in broad-market index funds. Bonds, with their historical role in diversification, often provide superior downside protection and Sharpe ratios compared to covered call strategies. A 40/60 stock/bond portfolio might further emphasize stability, incorporating high-grade bonds and inflation-protected securities (TIPS) to buffer against equity volatility.

Risk-Adjusted Returns: A Comparative Disadvantage

Risk-adjusted metrics highlight the limitations of covered call ETFs. From 2020 to 2025, these funds averaged a Sharpe ratio of 0.73, lagging behind the S&P 500's 1.05 and a bond index fund's 0.88. The Maximum Sharpe Ratio portfolio-a diversified mix of equities and bonds-achieved a Sharpe ratio of 1.24, underscoring the value of broader diversification. Additionally, covered call ETFs' maximum drawdowns, while moderate, are offset by high expense ratios and active management inefficiencies.

Conclusion: A Tool, Not a Panacea

Covered call ETFs can enhance retirement income in volatile markets, particularly when strategically allocated to tax-advantaged accounts. However, their long-term underperformance, tax inefficiencies, and limited downside protection necessitate a cautious approach. Retirees should prioritize diversified portfolios that balance income generation with growth and risk mitigation, using covered call ETFs as a complementary rather than core strategy. As with any investment, aligning these tools with individual risk tolerance and financial goals remains paramount.