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Past performance is no guarantee of future results. Content is offered for information purposes only. Unless stated otherwise, any and all individuals participating in the video are third parties that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body. Unless stated otherwise, the views or opinions expressed may not reflect those of Seeking Alpha as a whole.
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Daniel Snyder: Welcome back everyone to another episode of ETF Spotlight. I’m Daniel Snyder from Seeking Alpha. Today, we are diving into an interesting view on the conversation of covered call ETFs because our Seeking Alpha analyst today is Gary Gambino, and he recently wrote an article talking about two different ETFs that are focused on income that he argues might actually be better for investors than covered call ETFs.
Now, in his article, he did mention some of the big ETFs from NEOS Investments and all the love that they’ve been getting, and they’ve been on this show before. I’m sure you’ve seen the episode. If you haven’t, go back and watch that one. But, Gary, I want to jump into the conversation with you right now. You have a view on covered call ETFs. Let’s go ahead and get that out of the way, and then we can dive into these other two ETFs about income focus that you wrote about.
Gary Gambino: Sure. Well, my focus as investor is to maximize my total return. And what I’ve noticed is comparing the covered call ETFs to just generic index ETFs over time. The covered call ETFs tend to generate just a little bit less total return. So, if that’s your focus, there’s really no reason to be in. Now there are some people, obviously, retirees or whatever, who need or desire the extra income. And if they make an eligible trade-off that they’re going to sacrifice total return a little bit over time, that can be fine, but then even in that case, there’s some covered call ETFs that are better than others the way they manage things. So, my preference is to take an index ETF rather than generate the extra income by covered calls if you don’t need the income.
DS: So, where is that bleed of the total income coming from within those ETF structures?
GG: So, two things basically. Number one, they tend to have higher expense ratios. So, it takes more effort to sell the calls and manage it. And then number two, so when you’re selling covered calls, the biggest risk is that in a strong bull market, you’re going to give up some upside because your underlying possessions are getting called away. And so, you’re sacrificing upside to get that extra income.
DS: Got you. Got you. So, then you went and you wrote about DGRO and DIVO, two ETFs that provide income to investors as well. Why are you saying that these might be a more of an attractive look for investor portfolios?
GG: Okay. So, first of all, DGRO, that’s basically a dividend growth index ETF. And I really like the - even though it’s a passively managed index, I like the rules of the index, and though it’s constructed to really give you quality companies. So, number one, they weed out REITs and the top 10% of yielders. So things that tend to cut their dividends when things get rough. Number two, they require the underlying companies to have a five year history of dividend growth, and they have to have a payout ratio meaning the dividends divided by the income, of less than 70%.
So, they’re not stressing themselves by paying out too much income and they’re more likely to grow over time. And they actually tend to hold up if you compare DGRO versus just a simple S&P 500 index like SPY. They hold up better in bear markets because of the quality companies even if they underperform a little bit on the upside.
Then moving on to DIVO. Now there is a covered call ETF, but they do it in a very limited basis. So, they selectively sell calls against certain positions. They don’t sell it against the whole index, and they don’t sell them against the whole portfolio. And the fund manager has seemed to do a pretty good job of selecting those because they’re not stretching for income, they’re generating like 4.5%, I think, of yield relative to 2.5% for DGRO. But over time, the total returns have been pretty close. You’re not giving up that much total return to get that extra income with DIVO.
DS: I’m looking here on Seeking Alpha on the two different ETF pages we have for these, right? I’m looking at DIVO, it has 34 holdings with names like RTX Corp., Apple, Visa, Microsoft, JPMorgan, Goldman Sachs, The Home Depot. But then I’m looking over at DGRO, which has over 405 holdings. And there’s some names that are the same like, Apple and Home Depots on both of them, but it also has more like Broadcom and Procter & Gamble, UnitedHealth and names like that. How do you think about adding more number of holdings to something like DGRO versus something smaller like the 30 something in DIVO?
GG: Yeah. Well, the way I look at diversification is, you definitely need to have some, but beyond a certain level, there’s diminishing returns. So, it certainly looks like just looking at how DIVO has performed over time, it’s tracked DGRO total return pretty well. So, even though it’s, you got less diversification, it seems to be enough to give you the diversification benefit that you need.
So, DGRO is probably more diversification than you need, but it’s not hurting anything. It’s also not adding a whole bunch versus what DIVO is giving you.
DS: Now, I’m just wondering, can you walk me through these expense ratios for each of these? Because they’re drastically different when you go to look at those fees. For example, DGRO has expense ratio of only 8 basis points, and DIVO is rocking about 56 basis points.
GG: Yeah. So, I mean, like I said, DGRO is going to be your passive index fund, so they don’t really have to do anything, but replicate the underlying index. And DIVO is doing active management of the stock portfolio, as well as managing the Covered Call sales. So, that’s what you’re paying for.
DS: Now, you did write in your article that actually both of these ETFs are labeled as a Buy under your coverage. Just curious though. Could you break it out into like, investor buckets? Like, if you’re this type investor, go with DGRO. If you’re this type investor, then go ahead and go with DIVO.
GG: Yeah. Absolutely. So, I mean for both of them, I think they’re both good. Again, if you want a little bit less volatility relative to the total market. So, they’re going to, not do as badly in a bear market and maybe not quite as good in a bull market, but they are quality companies.
So, like I said, when we started, if you need the income, DIVO is fine. You are sacrificing a little bit of total return with the expense ratio, but they do a pretty good job of matching the index. DGRO, if you’re young and reinvesting the dividends, definitely that’s the better one for you. Anyone who’s reinvesting dividends in the covered call fund, is not doing the right thing. I would say, definitely go to the index fund in that case.
And then it’s going to, also, vary based on what your market outlook is. So, like I said, they both hold up better than the S&P 500 in a bear market. But, yeah, I was actually surprised to see that in a bear market, the covered call fund like DIVO actually holds up a little bit better. Obviously, the holdings aren’t hedged, so there’s no put options or anything protecting you there, but you are getting the option premium from the call sales. And since the stocks are going down at least they’re not getting called away. So, in that case the call premium gives you a little bit of income to compensate you for the bear market.
And then in a bull market, if you really think there’s a strong bull market, like I said, you don’t really want to be in the covered call funds because of the risk of getting called away.
DS: Yeah. Very good point there. Gary, wondering, when you go to do your research on Seeking Alpha and find ETFs like this that are focused on income or anything like that, how are you going about finding the names that you like to do your research on?
GG: Yeah. Well, that’s interesting. With this one, I just noticed a bunch of different covered call ETFs show up on the trending side on the front page of Seeking Alpha. So, I just started looking at them and trending the total returns over time. And I certainly compare, like we did, compare the holdings to see, what is the comparable covered call ETF versus a simple underlying index ETF, and turn the total returns over time, and pick a lot of different periods in up markets and down markets to see how they perform against each other, yeah, and go from there.
DS: Last question for you before we go ahead and wrap up here. Is there any difference in tax implications between these ETFs that investors should know about?
GG: Sure. So, DGRO and pretty much most index funds, they’re generally going to be qualified dividends. So, you’re going to, all the income that you get is dividend income, but it usually qualifies for the lower tax rate, because they’re stocks versus, if they are bonds or some other type of security, it’s not going to be qualified income. They’re going to be ordinary income. But DGRO is a good one where it’s almost all essentially qualified income.
Covered call ETFs are a mixed bag, so, it could be – the tax on, it could be anything from qualified, non-qualified, or return of capital. So, you really have to, if you’re thinking about getting into a covered call ETF, actually look at what they’ve done over time. If the covered call fund is paying up more distribution than they’re actually earning an income in any given period, you’re going to get some return of capital which is a deferred tax so you’re not paying any tax that year, but it lowers your cost basis and you end up paying more tax when you sell.
But again, it really varies based on the strategy of the covered call ETF, the mix of what the tax implication is on the distribution. It could be qualified, non-qualified, or return of capital. Definitely look into it before you invest in those.
DS: Now, between those, which would you say is like, the biggest risk that most investors aren’t really understanding about covered call ETFs? Because they’ve completely have ballooned in popularity over the last few years.
GG: Yes. People just see the yield and think they’re getting something for nothing and you’re not. You’re giving up the upside benefit in a strong bull market. And in the bear markets, you’re only getting a little protection from the call premium, and you’re not hedged on the downside. People say, oh, it’s lower volatility. Well, it’s lower volatility because the upside’s capped. If you turn this over, turn over time, you see you’re not really getting something for nothing. You are getting that extra income that maybe you need, but just remember you’re not getting it for free.
DS: Yeah. Let’s go ahead and wrap it up there. Gary Gambino, everyone, go follow him here on Seeking Alpha. He has tons of analysis coverage that he’s been putting out. I think you joined us in 2019, I think is, what I saw that you’ve been writing coverage on Seeking Alpha since. You’ve got a great following over there. Gary, just want to say thank you for the time today and bringing these two ETFs to life for us. Really appreciate it.
GG: Thanks. Thanks for having me.
DS: Alright, everyone. That’s going to wrap it up for this week. We will see you again here next week with another episode of ETF Spotlight. Take care.
**Seeking Alpha’s Disclosure: **Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.