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As the popularity of covered call exchange-traded funds (ETFs) grows, particularly those utilizing short-term options, many Korean investors are attracted by their high distribution rates. However, rising concerns centered around market volatility may lead to principal loss, highlighting the caution needed when venturing into these investment vehicles.
Given that a majority of these ETFs are linked to U.S. assets, significant fluctuations in the U.S. stock market can pose substantial risks for investors in Korea.
What are Covered Call ETFs?
A covered call strategy involves holding shares of stock and simultaneously selling call options against those shares to earn premiums.
Recently, financial institutions have unveiled second-generation covered call ETFs that leverage short-term options to enhance returns, particularly in bullish market conditions. This development fueled significant investment during last year’s rally in the U.S. stock market.
However, these ETFs are not without risks. The volatility of underlying assets can present challenges; unlike traditional investments, short-term option-based ETFs often prioritize option premiums over capital gains.
This means that while they can generate income through premiums, they may also absorb losses if stock prices decline. In highly fluctuating markets, these ETFs may not only fail to capitalize on rising stock prices but also incur losses when markets turn downward, potentially compromising their distribution models.
Risks of Principal Erosion and Dividend Reductions
To meet targeted distribution rates, these ETFs may experience principal erosion.
While many investors choose to reinvest their dividends, a significant drop in the ETF’s price may result in substantial losses upon selling.
Financial reports from the industry reveal that Mirae Asset Global Investments’ TIGER NASDAQ 100 Target Daily Covered Call ETF and TIGER S&P 500 Target Daily Covered Call ETF boast net asset values of KRW 657 billion and KRW 322 billion, respectively.
These ETFs, despite being relatively new to the market, have almost reached a combined value of KRW 1 trillion.
With tax advantages for overseas investments diminishing, many investors are increasingly leaning toward covered call ETFs with short-term options for potential tax benefits. However, it is essential to understand that these ETFs do not assure principal protection, particularly during turbulent market cycles.
Understanding Market Impacts Through Examples
Consider a scenario where a stock experiences daily fluctuations of ±5%.
Due to the nature of call-selling strategies, a short-term option-based covered call ETF is unable to capture the full upside (+5%), while simultaneously absorbing the downside (-5%).
As a result, substantial market downturns can hinder recovery efforts.
As market conditions deteriorate, several factors come into play:
- Declining option premiums lead to reduced available dividends.
- Falling asset values cause a drop in dividends as share prices serve as the denominator in the distribution rate calculation.
For instance, an ETF that originally provided KRW 1,000 in dividends based on a stock price of KRW 10,000 would see dividends reduced to KRW 500 if the underlying asset decreases to KRW 5,000, drastically impacting income.
Expert Recommendations on Risk Management
Lee Sang-min, head of Pluto Research, emphasizes that “Covered call ETFs tracking high-volatility U.S. tech stocks face significant hurdles in recovering principal and maintaining consistent dividends. When the focus is on maximizing distribution rates rather than stability, investors risk seeing their dividends and principal eroding.”
As interest in covered call ETFs escalates, it’s vital for investors to carefully evaluate their risk tolerance.
By recognizing the potential for capital depreciation and declining future dividends, they can make informed decisions before engaging with these high-yield investment strategies.
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