As a dividend investor, I'm always looking for investments that can generate sustainable streams of income. I don't always get it right (recent dividend-cutter Leggett & Platt comes instantly to mind), but more often than not, I've made good calls. The one income-generating tactic that I have yet to find a sustainable solution to is covered calls.
The Amplify CWP Enhanced Dividend Income ETF (NYSEMKT: DIVO) may change that.
What is a covered call?
Before getting into the details about the Amplify CWP Enhanced Dividend Income ETF and why I like it enough to buy it, we need to discuss covered calls .
There are different ways to generate income from investments. The one I favor most is collecting dividends, which is about as simple as it gets. You buy shares of a (hopefully) good company that distributes some of its profits to investors in cash via regularly scheduled dividend payments. Then, as a shareholder, you can simply sit back and collect those checks.
Image source: Getty Images.
You need to keep an eye on the companies you own, of course, but so long as the company is operating at a decent, if not high, level, investors can be pretty confident that the dividends will keep rolling in.
Another option that can be layered on top of the dividend approach is selling covered calls. Basically, this entails selling someone the right (i.e., an option), but not the obligation, to buy your stock at a predetermined price at some point in the future. You get paid a fee (called a premium) for selling that right, but you have to stand ready to sell the stock if the option gets exercised, or to buy back your call option to close the position. This obviously limits your upside potential in the stock -- if it rises enough to make the option profitable to exercise, the holder of that option will use it.
If the option doesn't get exercised, you keep the premium -- and your stock. That's income in your pocket. The problem for me is that I actually like the companies I own shares of, and I wouldn't want to be forced to sell them. (I spend way too much time picking them in the first place!) So my foray into selling covered calls was brief. But the allure of the income that selling covered calls can generate has always stuck in my mind. This is where exchange-traded funds (ETFs) like the Amplify CWP Enhanced Dividend Income ETF and the Global X S&P 500 Covered Call ETF (NYSEMKT: XYLD) come in.
How the Amplify CWP Enhanced Dividend Income ETF won me over
There are different ways to use covered calls, and I've cherry-picked the examples I'm going to use. However, the two extremes here are a curated portfolio with strategic covered call selling (the approach taken by the Amplify ETF) versus tracking an index and writing covered calls on that index (which is what Global X ETF does).
The fly in the ointment is that, very often, covered call ETFs push the envelope on yield in an attempt to attract investors. The Global X S&P 500 Covered Call ETF's yield is an eye-catching 9.2%. But think about that yield for one second: It's nearly as high as the roughly 10% average return investors expect from the S&P 500 index over time. Chasing yields at that level doesn't sound like a sustainable strategy -- and it may not be.
XYLD data by YCharts .
As the chart above shows, the value of Global X's ETF has declined over the past five years. If you look at its total return (which is included in the chart below), which assumes reinvesting the dividends , its performance looks much better. But I'm investing in an option income ETF for the express purpose of collecting and using the dividends. I'm not sure who would invest in an option income ETF for any other reason.
This is where things become problematic. A falling price means there's less capital in the ETF to invest. Less capital means a smaller portfolio upon which to write covered calls. A shrinking portfolio of covered calls means less income can be generated. That's a downward spiral that tells me I can't trust Global X S&P 500 Covered Call ETF to provide a reliable stream of income.
But look at that chart again, this time paying attention to the Amplify CWP Enhanced Dividend Income ETF. The value of that ETF rose over the past five years.
XYLD data by YCharts.
A rising value means there's a larger portfolio of assets on which to write covered calls. That means there's a chance for more income over time. That makes it an easy win in my mind.
But there's a trade-off. The Amplify ETF's dividend yield is "only" 4.4%. The ETF balances capital appreciation against option income as it looks to provide a reliable stream of income over time. And it appears to be the winning strategy. Notice that Amplify ETF's stock price gains alone were almost as large as the total return of the Global X ETF over the past five years.
I'm giving Amplify CWP Enhanced Dividend Income ETF a shot
To be fair, I'm not jumping in with both feet here. I only bought 100 shares of the Amplify CWP Enhanced Dividend Income ETF so that I'll have a reason to track it more closely. But I buy the story. Its managers cherry-pick a portfolio of dividend stocks they like and then strategically sell covered calls. That's what I would do if I were selling covered calls. Its 0.56% expense ratio is a bit steep for an ETF, but given the active covered call strategy, I'm not too concerned about it. (The investment managers in this case are actually doing something to earn that money.)
However, the bigger story here is that investors like me, who like dividends , need to be careful when looking at covered call funds of any sort. If the dividend yields are too high, the covered call strategy may not be sustainable. And if that's the case, you could just be getting your own shrinking capital back with every dividend payment. That's not a good deal.
I hope that the Amplify CWP Enhanced Dividend Income ETF proves to me that an option income strategy, executed well, can produce both a sustainable income stream and capital appreciation. If history is any guide, I believe it will.
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Reuben Gregg Brewer has positions in Amplify ETF Trust-Amplify Cwp Enhanced Dividend Income ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .
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