Hello, YieldAlley readers! In this issue:

🤖 Would the real AI bubble please stand up? (Deutsche Bank)

5️⃣ 5 Key Investing Themes From Warren Buffett’s Early Letters (Morningstar)

📚 My Favorite Investment Writing of 2025 (Of Dollars and Data)

💸 Three Tax Resolutions to Protect Your Income in 2026 (WSJ)

💰 5 money moves to make in 2026, according to financial experts (CBS)

Covered call ETFs have attracted over $100 billion in the past three years as income-focused investors chase yields that dwarf traditional dividend and bond funds. The strategy isn't new — traders have used covered calls for decades — but the ETF wrapper has made it accessible to retail investors seeking higher income without the complexity of options trading.

The appeal is straightforward: covered call ETFs can yield anywhere from 6% to 12% depending on market conditions, significantly more than dividend funds or investment-grade bonds. But that income doesn't appear magically. Investors are making specific trade-offs that make these strategies inappropriate for many portfolios, particularly for younger investors in accumulation mode or anyone holding these funds in taxable accounts.

The strategy involves owning an underlying asset (stocks or an index) and selling call options against that position. The call option works like an insurance contract — another trader pays a premium to buy the option, and that premium becomes the fund's income. In exchange, the fund is obligated to pay out if the underlying asset's price exceeds a predetermined level.

This creates a cap on upside potential. If the S&P 500 rallies 30%, a covered call fund might capture only 15-20% of that gain because the call options limit participation in strong rallies. The income from option premiums compensates for the sacrificed growth, but it's explicitly a trade: tomorrow's price appreciation for income today.

Option premiums vary with market volatility. When markets swing wildly, premiums increase and yields rise. When markets stabilize, premiums fall and yields decline. JPMorgan Equity Premium Income ETF (JEPI) has seen its trailing 12-month yield range from 6.5% to 12% since its 2020 launch. That variability matters for retirees counting on consistent income.

The broader derivative income category saw returns ranging from up 50% to down 40% in the first half of 2025, reflecting different underlying assets, varying option strategies, and wildly different fees ranging from under 0.20% to over 2.00% annually. A low-cost S&P 500 index fund would have beaten roughly 68% of these funds, highlighting the challenge covered call strategies face in delivering competitive total returns.

ETFs earn their reputation for tax efficiency by deferring capital gains. Covered call ETFs largely bypass this advantage because they generate income, not deferred capital gains. The income must be distributed and cannot be shielded by the ETF structure.

Option premiums typically fall under Section 1256 of the IRS tax code, splitting taxation between 60% long-term capital gains rates and 40% ordinary income rates. Some funds simplify this to ordinary income treatment, trading slightly higher tax bills for administrative ease.

The optimal account for covered call ETFs is a Roth IRA, where income escapes taxation entirely. Tax-deferred accounts like traditional IRAs are second-best. Taxable accounts are least suitable because the entire income stream faces immediate taxation, significantly reducing after-tax returns. This creates a paradox: investors seeking current income typically want distributions in taxable accounts, but that's precisely where these funds are most tax-inefficient.

JPMorgan Equity Premium Income ETF (JEPI) carries Morningstar's Bronze rating and stands out for its 0.35% expense ratio, which undercuts roughly 92% of funds in the derivative income category.

Portfolio manager Hamilton Reiner builds the underlying equity portfolio from S&P 500 stocks, providing broad diversification while constructing a defensively-oriented portfolio. He sells slightly out-of-the-money call options to preserve more upside potential while still generating meaningful premium income. The fund uses equity-linked notes rather than direct call options, simplifying tax reporting by converting all income to ordinary income treatment and eliminating complex Section 1256 reporting.

JEPI has accumulated over $30 billion in assets since its 2020 launch, with recent yields in the 7-8% range during calmer market periods.

Covered call ETFs serve a narrow use case: retirees or near-retirees in tax-advantaged accounts who prioritize current income over long-term growth. They are not appropriate for long-term wealth accumulation. A younger investor chasing 8% yields would be far better served by a low-cost S&P 500 index fund that delivers total returns through price appreciation.

Even for retirees, the variable income poses challenges. A yield that swings from 12% to 6.5% depending on market volatility doesn't provide predictable cash flow for budgeting purposes. Traditional dividend stocks or investment-grade bonds offer more stable, if lower, income streams.

The tax inefficiency in taxable accounts is severe enough that most investors should restrict covered call strategies to IRAs or other tax-sheltered accounts. For the specific investor who needs current income, holds these funds in tax-advantaged accounts, understands the growth sacrifice, and selects low-cost implementations like JEPI, covered call ETFs can serve a legitimate portfolio role. That's a narrow intersection of circumstances, explaining why these strategies remain specialized tools despite their recent popularity surge.

Government Money Market Funds (7-Day Yields)

Brokered CD Rates (6-Month Rate)

ETFs (30-Day Yields)

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