By Philip van Doorn
Exchange-traded funds employing covered-call options provide high monthly income and are becoming more popular with investors
Parag Sanghani of Westwood Holdings Group believes that energy prices are likely to remain stable. If you agree and are looking for investments that provide high levels of income, you might want to consider two funds that he co-manages.
There are many funds using option strategies to enhance income for their shareholders, and many of them make monthly distributions. Investors who like this strategy and need the income might be well served to examine a variety of approaches and funds to avoid having a high concentration in their portfolio allocated to any one fund.
The Westwood Salient Enhanced Midstream Income exchange-traded fund MDST holds 23 stocks of U.S. and Canadian companies that transport, store and distribute oil and natural gas.
The Westwood Salient Enhanced Energy Income ETF WEEI holds the 22 stocks in the S&P 500 energy sector.
Both funds were established in April and both pay monthly distributions, which are provided by the underlying stocks’ dividends and by premiums earned through a covered-call trading strategy. For both funds, the monthly distributions have been 23 cents a share since inception. The funds are actively managed.
Based on Tuesday’s closing price of $27.89 a share and the monthly distribution of 23 cents, the annualized trailing distribution yield for the Westwood Salient Enhanced Midstream Income ETF has been 9.9%.
And for the Westwood Salient Enhanced Energy Income ETF, the trailing distribution yield has been 12.18%, based on Tuesday’s closing price of $22.65 a share.
The funds have short track records, but below is more information about how the funds have performed relative to other exchange-traded funds tracking their benchmark indexes.
Extra income and lower volatility – for a price
Both of the Westwood energy funds trade covered-call options to enhance their monthly payouts. This not only enables them to provide income yields approaching or exceeding 10%, it lowers downside potential for shareholders. The price is that the funds give up some of the underlying stocks’ upside potential.
A call option is a contract that allows an investor to buy a stock at a particular price (called the strike price) until the option expires. A put option is the opposite, allowing the purchaser to sell a security at a specified price until the option expires.
A covered-call option is one an investor can write when they already own a stock. The strike price is typically “out of the money,” which means it is higher than the stock’s current price.
Here is a simple example for an individual stock: Let’s say you hold 100 shares of a stock that is currently trading for $100 a share. You like the stock but would be willing to part with it for $110. You sell a call option for a fee to an investor who believes the shares will trade much higher than $110 before the option expires. If the stock then moves above $110, you are forced to sell it for that that price. You keep your option fee but now need to find something else to invest in. But if the stock doesn’t rise above $110 before the option expires, you still keep your option premium and are free to write another call option.
A portfolio manager can continually write covered-call options to feed a steady stream of fee income. And if the underlying stock’s price is moving high enough that it appears likely to be called away, the manager can trade out of a covered-call option before it is exercised, or they can let the stock be called away and then make another stock purchase. Option premiums tend to rise during periods of higher price volatility.
During an interview with MarketWatch, Sanghani said that the strategy for both Westwood funds is to write covered-call options on most of the holdings.
Funds employ various covered-call strategies. Here are three other examples:
— The Eaton Vance Enhanced Equity Income Fund II EOS holds roughly 50 stocks and writes covered calls on all of them, and the managers tend to trade out of the option positions before they expire. We covered this 20-year-old fund and interviewed its managers in December.
— Another way to generate option premium income is to make use of equity-linked notes. This strategy is employed by the managers of the JPMorgan Nasdaq Premium Income Equity ETF JEPQ and the JPMorgan Equity Premium Income ETF JEPI. The latter fund has $39 billion in assets under management.
— A fund manager might also choose to be more opportunistic and write covered calls on only a few holdings at a time, depending on how much option premium income is available. This strategy is followed by Kevin Simpson, who co-manages the Amplify CWP Enhanced Dividend Income ETF DIVO.
Funds making use of covered-call strategies might return some of investors’ own capital as part of the distributions. There are various reasons funds do this – one is that price appreciation within a stock portfolio might provide “cover” to return some capital to investors without pushing a fund’s share price down very far. Another is that for an ETF, structural tax advantages can lead a portfolio manager to “roll the option to the next month” to book a loss, even after an option has been exercised leading to a gain on the sale of a stock, Sanghani said.
The bottom line is that if a fund returns some capital to investors, the effect is to lower the investment’s cost basis rather than distribute taxable income. This defers some capital-gains taxes until the investor sells the fund’s shares.
A broad covered-call strategy will lower a fund’s volatility while increasing investment income. This means lower downside capture when compared with an index, but also lower upside capture. Your risk is lowered while your income rises, but the cost is giving up some of an index or sector’s upside potential.
The case for the energy sector
Sanghani had a lot to say about the current scene for energy prices. But before we get to that, let’s look at a 15-year chart showing prices for continuous front-month contracts for West Texas Crude oil:
Leaving aside the market disruption during the early phase of the COVID-19 pandemic in 2020, the sharpest movement on the table above was the decline in crude prices from July 2014 through early 2016. That resulted from an oversupply, which eventually caused consolidation and some bankruptcies for U.S. oil producers.
Sanghani said that although he expected a continuing oil oversupply, the risk of another price collapse was tempered by the Organization of the Petroleum Exporting Countries acting as the industry’s “pressure value.” When asked if this meant that OPEC had ceded market share to North American producers, he said: “That is exactly how we see it. OPEC has cut production by about 4 million barrels a day.”
He continued: “Ultimately what OPEC wants is to make good money for the oil they are producing. They also want stability and sufficiently high prices to fund their budgets.”
OPEC “tried to do a price war in 2015 and 2016, which I think they thought hurt themselves as much as it hurt North America,” Sanghani added.
He went on to say that a $70 price for oil was “really healthy from a production and growth standpoint,” and that U.S. producers’ capital-spending discipline was lowering risk for investors.
“Ten years ago volumes grew 10% a year. Now it is 3% a year. It is a positive-feedback loop that gives OPEC the confidence to maintain price stability,” he said.
Performance so far
Sanghani said that investors could typically expect average annual price appreciation of about 6% for stocks of oil producers, midstream companies and providers of related services and equipment, plus dividend yields of about 3%, for “high single-digit returns” for the energy sector.
“So we looked at the income side. Volatility is priced very high in the options for this industry,” he said, referring to call option premium prices for energy stocks.
With less than a year since the Westwood Salient Enhanced Midstream Income ETF and the Westwood Salient Enhanced Energy Income ETF were established, we cannot present a detailed performance record. But both funds have fulfilled their objectives of making high monthly distributions.
The benchmark index for the Westwood Salient Enhanced Midstream Income ETF is the Alerian Midstream Energy Select Index. The index is tracked by the Alerian Energy Infrastructure ETF ENFR, which has a dividend yield of 4.27%, according to FactSet.
The benchmark index for the Westwood Salient Enhanced Energy Income ETF is the S&P 500 energy sector. This index is tracked by the Energy Select Sector SPDR ETF XLE, which has a dividend yield of 3.15%.
Here is how all four ETFs performed from April 30 through Tuesday, with dividends reinvested. Returns are net of expenses, which total 0.80% of assets under management annually for the Westwood Salient Enhanced Midstream Income ETF and 0.85% for the Westwood Salient Enhanced Energy Income ETF.
The Westwood Salient Enhanced Midstream Income ETF has returned 22.2% since April 30, while the Alerian Energy Infrastructure ETF has returned 34.7%. This shows the effect of the reduced upside capture when following the higher-income covered-call strategy.
Sanghani said that midstream companies (the oil and gas pipeline operators and distributors) had benefited from record production volumes for oil and natural gas in North America. He added that “in 2024, many companies were at or below leverage targets, allowing for free cash flow to be used for higher dividends and potentially more growth opportunities.”
He said the performance for the midstream stocks reflected “a realization by the market that we’ll be using natural gas for a very long time,” and that the build-out of data centers to support generative artificial intelligence technology would lead to higher usage for natural-gas power plants.
(MORE TO FOLLOW) Dow Jones Newswires
02-19-25 1024ET
Copyright (c) 2025 Dow Jones & Company, Inc.
