Covered Call ETFs: The Good, the Bad and the Fugly

Real world examples of return of capital

I am experimenting with a new style…

What follows is a series of infographics rather than prose. It is like a slide show or zine; my goal is that the concepts are easier to absorb when presented visually.

The Fugly?

“Return of capital” is an interesting tax hack. It effectively allows ETF (and other 40 Act fund) shareholders to receive their principal back, untaxed, while the portfolio balance keeps growing.

This can be a powerful tax deferral mechanism, but if taken too far, the fund must raise capital to pay existing shareholders. If that sounds like a Ponzi scheme, it sort of is, in concept. That’s the fugly.

In reality, fund managers keep a close eye on distributions, and temporary cases of “principal erosion” are normal. But they do limit growth since the portfolio is smaller.

See the background and examples below to learn more.

Without further delay, here is a quick guide to return of capital, including 4 real-world examples from the XYLD covered call ETF.