On why high-yield Income Shares ETPs can be risky, how they work, and the dangers of capital erosion.
Every now and again, there are some financial products that catch on and spread like wildfire within the investing community.
Currently, it’s the High-Yield Income Shares ETPs.
It’s not hard to see why; they are nicely packaged, easy-to-use products that offer the biggest yields you will probably see out there.
As they get popular, more of those types of products are launched, and the market is full of them.
With the rising popularity and potential for smaller portfolio sizes to have enough yield to cover a larger amount of your monthly bills, many people are adding them to their income portfolios.
However, I am mostly staying away, but that doesn’t mean you have to.
In this article, I’ll explain why these products are not for me.
The Structure of High-Yield Income Shares ETPs
Investing Philosophy: Buy What You Want to Own
Part of my philosophy of investing is “Buy What You Want to Own.”
This maxim or tenet is mainly to act as a guardrail against the mentality of buying something in the hope that you can sell it for a higher price later.
In other words, it’s a safeguard against the Greater Fool Theory: buying something you don’t genuinely want, simply hoping there will be a “greater fool” to sell it to later.
For example, I never bought an NFT during the craze. Lots of money was flying around at the time, but now the hype has died down, and people who paid exorbitant sums are left with very unremarkable images of monkeys.
The greater fool theory doesn’t relate to these Income Shares exactly, as you are not hoping to sell them at a higher price; realistically, you are hoping for massive income.
However, the premise of “buy what you want to own” does.
High-Yield Income Shares ETPs Are Financial Derivatives
The structure of Income shares ETPs means you don’t really have a stake in any ownership of any shares; it’s a financial derivative.
Conversely, when you buy a share of a company, you become a shareholder or partial owner of that company.
It’s abstracted with markets trading every day with loads of shares changing hands.
But if you go super reductionist for a minute, you can think of each company with loads of owners, each with a claim on the company.
Sometimes, if you own enough of the company, you could have a say and vote for the future direction of the company.
The Dividend Academy explores this shareholder mindset and dives deeper into what it actually means to own a share and participate as a partial owner of a company.
Value Creation: Real Companies vs High-Yield Income Shares ETPs
I believe in buying companies that pay sustainable income based on genuine economic activity, i.e., they add value in some sense, to the world.
Take a gold mining company, for example. It invests time and effort to extract gold, which people value.
Then, because people like gold so much, it can sell them for money and add value to the world.
If it makes more money than it costs to find and dig out the gold, then it makes a profit, and it can share some of the profit with the shareholders, which could be us if we decided to buy shares.
Now, when we look at financial derivatives like these income shares ETPs, it’s more like betting on the price of those shiny rocks, rather than actually owning the gold mine itself.
You’re not part of the basic process of creating value; instead, you’re speculating on how prices might move or getting income from a complicated financial setup.
The ETP itself doesn’t create new value; its value comes from something else it’s based on, often through clever financial tricks to create income.
This means the income isn’t directly from a company making products or services, but more from financial arrangements or leveraging.
Therefore, unlike a gold mine, which adds real value to the world by digging out physical gold, these financial tools simply represent claims on other assets.
Their risks and rewards can be quite different and often harder to understand than just owning a business.
How High-Yield Income Shares ETPs Work
These ETPs first own an underlying asset, like shares of a major company or a stock market index.
Then, they effectively ‘rent out’ the potential upside of these assets by selling call options.
A call option gives its buyer the right to purchase those shares at a set price by a certain date.
In exchange for this right, the ETP receives an upfront payment, known as a premium.
This premium income is the part that investors seek for yield, regularly collected and then distributed to the ETP’s shareholders.
The strategy is called ‘covered’ because the ETP already owns the shares it’s offering, making the process less risky than selling options on assets they don’t possess.
So you can’t think of it as a dividend, as in a share of a company’s profits. It’s much more complicated.
Covered call ETPs are essentially a bet on a specific market condition.
The Market Conditions Behind Covered Call Income
Covered call ETPs are designed to generate income, but their performance is highly dependent on market conditions.
They generally work best in these environments:
Sideways or Flat Markets
This is their ideal sweet spot.
When the underlying asset trades in a relatively narrow range, neither rising nor falling significantly, the ETP can repeatedly sell call options that expire worthless.
They keep collecting the premiums without having to sell their underlying shares or suffer significant losses on the underlying.
This allows them to maximise their income generation.
Moderately Rising Markets
In a market that is slowly but steadily increasing, the ETP can still collect premiums.
If the price rises enough to hit the strike price, they might sell the shares, cap their gains, but still keep the premium.
They participate in some of the upside, but their overall return lags a pure investment in the underlying asset because their upside is limited.
Moderately Falling Markets
If the market experiences a moderate decline, the premiums collected from selling calls can help offset some of the losses from the falling value of the underlying assets.
The income acts as a partial buffer. However, it won’t fully protect against steep declines.
Any other market conditions, and you are a loser, essentially.
If the market is volatile, the premium is often high, but you either lose more of the upside or suffer when the stock falls too.
When you buy this kind of ETP vs just buying the underlying, you are basically saying, “I think that the stock price will be relatively flat and want to benefit from that.”
If you don’t believe that, then it’s better to buy the underlying and sell off little bits as it rises – or manufacture your own dividends.
Example 1: TSLY vs Tesla Stock
TSLY is one of the popular iterations of this type of fund and has been around longer in the US than many of the ones available in the UK and Europe today, so it has more of a history to go against.
To understand how it behaves, it helps to compare it directly with its underlying asset: Tesla stock (TSLA).
Starting with year-to-date results from a $10,000 investment:
Holding cash, represented by the 3-month treasury bill rate, shows slow but steady positive growth. It’s not impressive, but it preserves the capital.
Tesla stock has taken quite a dip this year; it’s not been a great year for them, so they end this period so far on a negative note. A $10,000 investment in Tesla stock is worth about $8,579 as of now.
Tesla stock is the underlying asset used in TSLY, but with income generated through options, TSLY ends up lower than Tesla itself. The same $10,000 invested in TSLY falls to around $6,503.
At this point, it’s fair to say this isn’t a like-for-like comparison, as the goal of TSLY is income.
Equalising for Income
To make the comparison fairer, let’s try to equalise the two at the same dividend rate.
We reinvest all of the income of TSLY, so we are measuring the total return, but withdraw 20% from both at the beginning of each year to make an equalised yield of 20%, which is pretty substantial income by anyone’s measure.
Treasury bills clearly cannot maintain a 20% yield, which is why their value steps down at each withdrawal to pay for living expenses.
In this time period, both TSLA and TSLY have increased in value, so it’s not all doom and gloom.
But once again, TSLA has outperformed TSLY – in this circumstance, you are better off just holding TSLA and withdrawing 20% manually than playing around with all the derivatives.
If you reinvest the dividends and don’t make any withdrawals, Tesla once again sits at the top in terms of total return.
This comparison is based on a short history, as TSLY was only launched at the end of 2022, meaning the data mainly reflects 2023.
Example 2: QYLD vs the Nasdaq 100
Another comparison can be made using QYLD, which has a much longer history. While its yield hasn’t been as eye-watering, it operates on the same covered call premise.
It’s a different company that created and maintains it, but it works in the same kind of way.
QYLD is a covered call fund on the Nasdaq 100, with data starting from 2016. Over this period, Cash shows not a very impressive rise, as you would expect.
QYLD ends the near decade below its starting point, which is kind of expected as it’s been paying out to us.
But what is shocking is how far the Nasdaq 100 has diverged from its covered call fund. The opportunity cost is significant.
Equalising again for income, assuming a 12% annual withdrawal from the Nasdaq 100 (roughly in line with QYLD’s historic yield), QYLD still ends in negative territory.
Once again, we see that kind of step down in cash as it can’t maintain a 12% yield.
QYLD also ends in the negative; however, what is surprising is that the NASDAQ 100 is still positive despite paying out a 12% yield each year to us.
Therefore, looking back, if you liked the idea of holding the QYLD covered call over the long term for income, it actually made more sense to just buy the Nasdaq 100 itself and sell off 12% at the start of the year.
Bearing this in mind, I see these covered call ETFs as a low upside play with an unreliable yield.
They make sense in very specific market conditions; however, those market conditions are quite rare to see play out, so the situations in which you would prefer them to the underlying are quite limited.
The “Return of Capital” Aspect (When the underlying asset falls)
Imagine the ETP holds shares of a company worth $100. It sells a call option and collects a $1 premium. This $1 is distributed as income.
Now, if the company’s share price falls to $95, the ETP has lost $5 in capital value.
The ETP still distributes the $1 premium as income. But because the underlying asset has lost value, a portion of that income distribution is effectively coming from a shrinking capital base.
This is where the return of capital concern arises.
If the income distributed consistently exceeds the actual net profit (premiums collected minus capital losses on the underlying), then the ETP is effectively paying you back part of your initial investment.
Your share price in the ETP will gradually decline over time as its net asset value (NAV) is depleted by these distributions.
Why Is the Return of Capital a Problem?
The three main issues at play here are:
- NAV Erosion: If the ETP is consistently distributing more than it’s truly earning (after accounting for capital losses on the underlying), its (NAV) per share will erode over time. This means your initial investment slowly loses value.
- Misleading Yield: A high “yield” percentage can be very attractive, but if a significant portion of it is effectively your own capital coming back to you due to capital erosion, it’s not sustainable and can be detrimental to your long-term wealth.
- Tax Implications: In some jurisdictions, returns of capital distributions have different tax treatments than ordinary income or capital gains. It’s crucial to understand this, though tax treatment varies depending on personal circumstances, and this should not be taken as tax advice.
A Wizard Analogy to Illustrate the Risk
Imagine a wizard presenting you with a ‘magic money box.’
He boasts, ‘Deposit £100, and it guarantees a humongous 50% yield per year!’
You place your £100 inside, and exactly one year later, true to his word, the box ejects £50.
But then, you decide to retrieve your initial investment.
Peering into the box, you discover only £50 left.
The ‘yield’ was technically paid, but half of your original capital was returned to you as part of that payment.
The magic, it turns out, was simply giving you back your own money, piece by piece.
Just as you process this realisation, the wizard reappears with a flourish, extends his hand, and calmly informs you, ‘Oh, and that’ll be my annual management fee, good sir. A tidy sum for the upkeep of the box, of course.‘
He then promptly pockets another few pounds from your remaining £50, further diminishing your initial investment.
This is unlike a “true” dividend, where it is, or should be, from the value generated by a company.
Conclusion: Why High-Yield Income Shares ETPs Look Better Than They Are
While those eye-catching yields from Income Shares ETPs can certainly be alluring, promising a steady stream of income, it’s crucial to understand what’s really happening under the surface.
These high payouts can lure investors with the promise of easy money, but they often conceal how your initial investment might shrink and how these funds cap your upside gains.
As we’ve seen, the ‘yield’ isn’t always a true profit from productive business activity.
Instead, the ETP often returns your own money to you piece by piece and then takes a portion through management fees.
These products only truly shine in specific, often short-lived, market conditions, and they can significantly lag simply owning the underlying asset during strong periods of growth.
Ultimately, my core philosophy remains: “Buy What You Want to Own.”
Focus on companies that create real value, earn profits from their tangible contributions to the world, and genuinely share those earnings with their shareholders.
Don’t let yields that sound too good to be true tempt you, only to quietly erode your principal.
A clear understanding of how these products truly function, beyond the big percentage numbers, is your best guide to making sound investment decisions.