This type of ETF is designed to hedge against volatility and help investors navigate a stormy stock market

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Hello! This is MarketWatch reporter Isabel Wang bringing you this week’s ETF Wrap. In this week’s edition, we look at covered-call ETFs, which use an options strategy known as covered-call writing which may limit potential upside participation but generates income for investors in volatile markets. Please send tips, or feedback, to isabel.wang@marketwatch.com or to christine.idzelis@marketwatch.com. You can also follow me on Twitter at @Isabelxwang and find Christine at @CIdzelis. Sign up here for our weekly ETF Wrap. This week’s stock-market volatility is the latest reminder that it is time to revisit risks and play defense in your investment portfolio. The CBOE Volatility Index VX00, -1.33% , known as Wall Street’s fear gauge, rose as high as 18.14 on Tuesday, its highest level in over two months, according to FactSet data. Investors in exchange-traded funds who are looking for alternative income solutions while avoiding market volatility in the rising interest-rate environment may want to consider covered-call ETFs as part of their defensive portfolio, said Rohan Reddy, director of research at Global X ETFs. A covered-call ETF, or an option-income ETF, is a fund that uses an options strategy called covered-call writing to generate income through collecting premiums. In a covered-call trade, investors sell a call option on an asset they hold, which gives the buyer of the option the right, not the obligation, to purchase the asset from them at a specified “strike” price on or before a certain date. When the price of the asset goes down and doesn’t reach the “strike” price before the expiration date, the call option will expire as buyers walk away, but investors could still keep the premium as their payouts. However, if the asset rises above the “strike” price, the option buyer has the right to purchase the underlying asset at that price. Investors still keep the premium as income, but they miss out on any additional gains on the stock they own unless they buy back the option at a loss. “That means you give up the upside, but the plus for the investor is because you need to be compensated for giving up the upside, you get a higher level of options premium,” said Reddy in a phone interview on Thursday. That’s why the covered-call strategy usually performs best in what Reddy called “sideways or choppy market environment,” where there are no clear trends found in the markets. “That might imply there could be higher volatility so you’re getting higher premiums while also potentially outperforming the market in that environment.” The use of this defensive equity strategy gained popularity during the long period of low interest rates in 2020 and 2021, and became even more popular last year when markets closed out their worst year since the 2008 financial crisis as the Federal Reserve aggressively raised interest rates to curb the highest inflation in 40 years. See: Looking for stock dividends of 9% to 11%? That’s what these ETF managers are aiming for with an AI-aided strategy. The largest U.S.-listed covered-call ETF, the nearly $29 billion JPMorgan Equity Premium Income ETF JEPI, brought in record inflows for an actively-managed ETF of over $12.8 billion in 2022, according to FactSet data. Other covered call ETFs were also popular. The Global X Nasdaq 100 Covered Call ETF QYLD and Global X S&P 500 Covered Call ETF XYLD saw $2.7 billion and $1.7 billion of inflows in 2022, respectively. JEPI lost 3.5% in 2022, compared to a 19% of decline in the large-cap benchmark S&P 500 SPX, while XYLD lost 12.1% and QYLD dropped 19.1%, far outperforming the Nasdaq 100 NDX’s nearly 33% decline, according to FactSet data. “The overwhelming majority of our clients use these funds for income, so they’re less sensitive to the way that the markets are going,” Reddy said. “A lot of it goes back to even though inflation has fallen this year, it’s still hard to find real incomes – you need to stretch in an environment where it’s getting harder to get real cash flow, that’s why we’re seeing these alternative sources of income, particularly in the derivative space with these covered-call strategies that come more popular.” See: An ETF that can’t go down? This new ‘buffer’ fund is designed to provide 100% protection against stock-market losses In 2023, as the stock-market rally that marked the first half of the year continues into the second half, these funds have been lagging the major indexes. JEPI rose 7% so far this year, while XYLD was up 10.6% and QYLD jumped nearly 20% year-to-date – less than the 38% advance in the Nasdaq 100 and the 16.4% gain in the S&P 500, according to FactSet data The flows into these ETFs also slowed down in 2023, with XYLD collecting $687 million in 2023 and QYLD has attracted over $1 billion over the same period, according to FactSet data. Reddy pointed to the recent “FOMO” rally led by megacap technology stocks, which made covered-call ETFs’ investors unable to capture all the upside in an uptrend market. “If the Fed does engineer a soft landing, I think giving up the upside is maybe more challenging for investors. Maybe that’s why some of the flows recently have slowed down, but overall, they’ve been pretty good,” he told MarketWatch. Meanwhile, there’s still concern about whether the current rally is sustainable as the rest of the stock-market hasn’t fully caught up with the big-tech companies, while investors are still assessing if July’s report on consumer prices could spell the end of Fed’s interest-rate hikes. “We could see at least lower-for-longer returns going forward, maybe not necessarily a major downturn, but a more choppy market environment,” Reddy said. “So something like a covered-call strategy would honestly be an ideal solution.” See: U.S. inflation rate creeps back up, CPI shows, but probably not enough to worry the Fed As usual, here’s your look at the top- and bottom-performing ETFs over the past week through Wednesday, according to FactSet data. The good… Top Performers %Performance United States Natural Gas Fund L.P. UNG 15.8 Invesco High Yield Equity Dividend Achievers ETF PEY 4.1 SPDR S&P Oil & Gas Exploration & Production ETF XOP 3.6 PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF ZROZ 3.3 Vanguard Extended Duration Treasury ETF EDV 3.1 Source: FactSet data through Wednesday, August 9. Start date August 3. Excludes ETNs and leveraged products. Includes NYSE, Nasdaq and Cboe traded ETFs of $500 million or greater. …and the bad Bottom Performers %Performance ARK Next Generation Internet ETF ARKW -6.8 ARK Innovation ETF ARKK -6.3 ARK Fintech Innovation ETF ARKF -5.3 WisdomTree Cloud Computing Fund WCLD -4.8 SPDR S&P Health Care Equipment ETF XHE -4.8 Source: FactSet data New ETFs USCF Wednesday announced it has launched the USCF Sustainable Commodity Strategy Fund ZSC which seeks total return by providing broad exposure to commodities across three different sustainability focused themes: agriculture, renewable energy and electrification. Weekly ETF reads