⭐ SPYI: Another Rockstar Covered Call ETF

👉 Almost Memorial Day Weekend!

Before we roll into the holiday, we’re back to share another great breakdown.

This time — it’s revisiting SPYI.

⚡️ Introduction:

You may recall my post from February about QQQI — the NEOS Nasdaq-100 High Income ETF.

I then shared another analyst’s point of view on the QQQI ETF in this post last month:

After each of these went live, I received dozens of emails from you all about your experience with income-focused ETFs — or simply wanting to learn more.

So now I’m back to share more details about SPYI — the NEOS S&P 500 High Income ETF. 

If you’re a regular reader around here, you know that I love having income-focused ETFs in my portfolio. I’ve mentioned SPYI to you numerous times in our Week in Review posts and I’ve broken it down fully on Seeking Alpha as well.

Our friend, Nicholas Bratto, wrote another great overview about it — so we requested his permission to share it here with you!

He’s also got his very own Substack that you can check out here.

As a disclaimer, the following analysis was conducted by Nicholas and the writing is in his own words. As always, none of this should be construed as financial advice. Also keep in mind that the charts here are from when he posted this piece last week.

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As always — feel free to comment below or respond to this email with any questions!

Summary

• SPYI is a strong income investment choice in the covered call option ETF arena offering predictable & tax efficient income with upside capability.

• Through a detailed backtest, withdrawing 8% annually, with dividends partially reinvested, achieved a balance between income and inflation-adjusted returns.

• Risks like performance history and capital preservation are assessed and what you can do to manage the risks.

How much money is enough? What makes you feel more secure: $2,000,000 in the bank or $10,000/month for the rest of your life? In my pursuit of financial security, I'm constantly faced with the net worth vs. cash flow debate. Investors on social media debate growth vs. dividends frequently. Income investing is even more taboo unless you're 60+ years old. As I've studied, challenged, and improved my personal finances & investments, I learn more about what I want out of life than about finance. Money is not intrinsically valuable: it's a tool to exchange goods, services, and your time. Balancing growth and income is key to providing robust cash flow.

SPYI Refresher

In November 2023, I wrote an article on Neos S&P 500 High Income ETF detailing what the fund is and how it works. Here's a link to the article I wrote SPYI: High Income And Capital Appreciation, You Can't Have Both so readers can learn in-depth about the fund. My main concern with SPYI and other option income ETFs is always capital preservation/appreciation as a means to outpace the rate of inflation.

While I still agree with my analysis that 12% is too high of a distribution to accept as is, it doesn't mean there's not a use case for SPYI to provide high income and capital appreciation: it just requires a little cash management.

As I've been learning more about income investing and revisiting my thesis, I realized you can in fact have both high income and capital appreciation through proper management of the distributions, management buying call options, and equity appreciation. This drove me to refine my thesis and as you can see: the title of this article. I believe using the 8% rule is a realistic strategy to invest in SPYI and achieve a cash flow which can outpace inflation.

What makes funds like SPYI so attractive to income investors is undoubtedly its high yield, but the fund has several other positive features, making it a strong income investment choice. In addition to the high yield, SPYI offers

1. Predictable monthly income

2. Tax efficiency

3. Active strategy to manage the NAV

To achieve the predictable monthly income, the fund sells cash-settled European style options using SPX Indexed options. Additionally, fund management has a goal to distribute 1%/share each month as shown below.

The predictability of the monthly income is one of the most important anchors for forward-looking assessments of SPYI. Knowing that the target is 1%/share allows investors to predict their distributions when the fund rises and falls. This would likely be a lot different if you tried to replicate this strategy yourself. Ironically, the fund uses market volatility to generate a stable return.

The fund layers its tax efficiency strategy with several methods:

• The contracts sold are taxed 60%/40% long/short-term capital gains tax rates respectively per Section 1256 contracts.

• Part of the fund earns qualified dividends from the equities held.

• Utilization of Tax-loss harvesting.

• Uses Return of Capital (ROC) classification on the distributions, which essentially makes > 90% of the distributions deferred long-term capital gains.

I mentioned the active strategy of managing the NAV because knowing the fund's goal is to distribute 1%/share, stabilizing and growing the NAV is the key to growing the distribution to outpace inflation. The fund managers accomplish this by reinvesting excess income back into the fund and by buying call options when the VIX is < 10. Of course, when the underlying equity value increases, so too does the NAV and income, but no one has control of this change.

A Case For The 8% Rule

I've been building a dividend growth & income portfolio to fully offset my emergency fund and cover my "fixed" expenses which are about $2600/month. Using the 4% rule, I'd need to invest about $780k to cover my fixed expenses: subscriptions, phones, insurances, water, internet, energy, property taxes, groceries, CapEx, etc. These are expenses that will never go away, even if you're debt-free. With SPYI, I'd only need to invest about $260k using the current 12% distribution yield, or would I?

There's no point in using the 4% rule with an investment like SPYI; otherwise, you would simply invest in the underlying holdings, like SPDR S&P 500 ETF Trust (SPY). However, in my experience and analysis, I don't believe it's wise to take the full distribution from SPYI and covered call ETFs in general. However, there is something called "the 8% rule" which I've learned more about from popular Seeking Alpha Analyst and author of The Income Factory, Steven Bavaria and the YouTube channel Armchair Income.

The idea is to structure an income portfolio with investments which provide a reliable and predictable yield usually 8-10%, regardless of market conditions. Covered call ETFs are one such investment apart of this group. It is certainly less mainstream and more recently, was the subject of a highly controversial take by Dave Ramsey when he bashed the 4% rule on the Ramsey Show.

In the table above, I compare SPYI's average distribution each year, the income growth, and the average inflation rate. Although the distribution has grown above 2%, inflation is not always 2% each year, as we've all been relentlessly experiencing these last few years. Cumulatively, the distribution increase has been 4.56% vs. 5.17% for inflation. Therefore, I believe taking a 12% distribution leaves too little margin for your income to keep up with the rate of inflation.

Next, I ran a backtest on SPYI from January 2023-April 2024 assuming an investment of $300k (to have some buffer for my income requirement), withdrawing a monthly percentage based off an annualized withdrawal rate, and dividends reinvested according to the difference in the withdrawal rate e.g. if you withdraw 8% you're reinvesting 4% of the distribution. With this setup, we can study the performance of the investment in a realistic way an income investor would actually use the fund. Of note, I used January 2023 and not the fund's inception date of September 2022 in order to compare the distribution growth vs. the inflation rate.

In the chart above, I plotted the annualized withdrawal rate vs. the annual cash flow on the primary y-axis and the inflation adjusted CAGR on the secondary y-axis. Two things stood out to me: using a 6% or 8% withdrawal rate does not achieve my income goal of $2600/month ($31,200/year) and a withdrawal rate of 12%, i.e. not reinvesting dividends, resulted in a negative real return of -0.86%.

*Note the 12% value in the table/chart was rounded from the trailing yield over the timeframe without dividends reinvested. This was done to see how the investment would have held up based on price performance alone, i.e. taking the full distribution and seeing if your income will still grow.

The 10% result barely outperformed inflation and 6% is too conservative for my liking. I believe using an 8% withdrawal rate resulted in the best balance of income and inflation adjusted CAGR. However, since we used 8% we have to invest a bit more to achieve the desired income level so I reran the backtest using $425k instead, building in a realistic buffer of 15% I based off of the most recent average drawdown of the S&P 500 in 2022 of 13.8%. This achieves my cash flow goal of $2600/month and hedges against inflation and market drawdowns.

Looking ahead, I believe inflation will cool back down to around 2% and interest rates will actually stay somewhat elevated for the foreseeable future, taming this wild market we've had the last 4 years. Both of these macroeconomic effects would improve these results a lot going forward because inflation takes less of a bite out of the returns and a slower rising market allows a fund like SPY to not only do well, but potentially outperform the broader market some years too.

Risk Analysis

The first risk to my thesis is the limited performance history we have on SPYI. A fund this new requires careful monitoring to ensure you get a real return on your investment. A quick backtest on the popular covered call fund Global X S&P 500 Covered Call ETF (XYLD) which I wrote about last year in-depth, shows the 8% rule from the fund's inception would result in capital erosion. However, XYLD uses a different strategy: at-the-money (ATM) calls only and in fact prior to the fund changing its options strategy in August 2020 from a 2% Out-of-the-money (OTM) strategy to the ATM strategy, the fund had a positive real return. SPYI sells layered OTM covered calls and has the ability to buy calls.

These levers give me confidence the fund has a higher probability for the NAV to not erode. This is supported thus far by a Sharpe Ratio of 1.14 for SPYI, indicating acceptable performance compared to the performance of the risk-free investment, which is pretty competitive considering the rate T-bills are at.

The next risk we cannot control is the underlying equities/market declining in the future, which would cause a decline in income. To manage this risk, I believe it's wise to overestimate your income needs. In my case, I used 15% but one could make it as high as 25% to weather a prolonged downturn. As is for personal finance in general, when times are good, one should always try and get ahead so you're better prepared to handle the bad times. For income investors, this means reinvesting more money into the fund when you're doing well to narrow the margin of safety needed over time.

Outlook

All in all — I'm intrigued by SPYI and NEOS NASDAQ-100 High Income ETF (QQQI) for that matter as strong income investments. The predictable monthly income, tax efficiency, and capital appreciation strategy make for a strong income investment choice and doesn't require saving millions of dollars to pay the fixed expenses I can't escape. I believe a realistic income investment strategy is investing in both SPYI and QQQI, which I wrote about last month, and utilizing the 8% rule to cover my fixed income needs.

One improvement fund management could make is lowering the distribution to an appropriate level so investors don't have to manage/worry about capital preservation. I think the right range is between 7-10% to balance the income edge of the strategy and to not erode the fund's NAV. This is supported by both the backtests presented above and the more conservative S&P 500 average annual rates of return often cited and used for forward planning. Though, perhaps the strategy itself does not risk capital erosion as much as I think, time will tell.

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Disclaimer: This is not financial advice or a recommendation for any investment. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.