(Bloomberg) -- A big story of investing in 2023 has been the craze for exchange-traded funds that marry equity exposure to streams of income wrung from the options market. More than $20 billion has flowed to them — mostly from retail traders — in the never-ending search for yield. 

Alas, the latest research suggests buying the funds for the express purpose of pocketing the extra money is a mistake, with gains eaten up by losses connected to the very options that traders were counting on to buttress returns.

In a new paper, quant veteran Roni Israelov, the chief investment officer of Boston-based financial services firm NDVR, says one version of the trade has bled money since 1999, with performance worsening over the past decade.

“I call this a Devil’s Bargain,” said Israelov, a former principal at AQR Capital Management. “People are giving up return in order to get income, which I believe is questionable.”

His work casts a sober eye on the frenzy for funds like the JPMorgan Equity Premium Income ETF (ticker JEPI) and the Global X Nasdaq 100 Covered Call ETF (QYLD), which sell options to augment stock portfolios. After many of them beat the market handily in 2022, derivative-income ETFs have seen their assets surge 70% to about $60 billion this year, by one estimate.

Here’s how the strategies work: Managers pick a portfolio of stocks, then sell options against them, sending the proceeds to shareholders. On its website describing JEPI, JPMorgan refers to money harvested from the sale of options as “monthly distributable income,” while Global X says the process “historically produces higher yield in periods of volatility.”

While far from a wholesale rebuke of ETFs keyed to the technique, Israelov’s paper essentially argues that the extra income is a mirage, with the cost of settling the contracts consistently offsetting the money received selling them. The paper unpacks various scenarios in which hypothetical options trades targeting yields of 6% and up have lost between 0.5% and 1.4% a year. 

Yield is a concept in finance that seems simple but gets more complicated when examined closely. Stocks pay dividends, and are touted by brokers for their cash-generating qualities. But rarely is it mentioned that a stock’s price falls when the dividend is paid. With ETFs purporting to find extra money selling options, Israelov is making a related point: there’s no free lunch. A payout that looks “extra” usually comes at a price.

His beef isn’t so much with how the funds perform as it is with what investors believe they are getting when they buy one. He concedes that owning portfolios of stocks has historically been a money-making trade, and it’s possible for the strategies to offer attractive returns at reduced risk to the right customer.

Nevertheless, “some investors might be attracted to covered calls for the wrong reason, seeking income rather than equity and volatility risk premia,” he wrote. They might also have “optimistic return assumptions guided by stated and delivered derivative yield,” according to Israelov.

Rohan Reddy, head of research at Global X, says the analysis may be misleading given its conclusion is based only on the options leg of the trade, leaving out the stocks. He also questions whether the study’s time period, one where stocks experienced a strong upward trajectory, has led to a false impression that the strategy doesn’t work.

“The term ‘Devil’s Bargain’ is an inappropriate hyperbole to simply describe that selling a covered call is a trade-off of upside participation for premium income,” Reddy said. “At the end of the day, investors are not necessarily utilizing covered calls to outperform broader markets or as a gateway for upside participation,” he added. “The main benefit is ‘bird in hand’ income through the form of premiums.”

A JPMorgan spokesperson declined to comment on JEPI’s strategy. 

Last year, when stocks plunged, JEPI beat the S&P 500 by more than 10 percentage points and QYLD was ahead of the Nasdaq 100 by a similar amount. While their performance has lagged this year amid the market advance, money kept pouring in. 

Israelov, in the interview, emphasized that the study is not intended as a criticism of funds such as JEPI and QYLD. Those strategies are valid for investors willing to give up some upside in stock holdings in exchange for lower volatility. What he’s cautioning against is using them as a simplistic way just to earn income. 

In the paper titled “A ‘Devil’s Bargain’: When Generating Income Undermines Investment Returns,” Israelov and colleague David Nze Ndong stress the distinction between immediate income and longer-term returns. Generating income is only the first step of an option transaction that also binds investors to an obligation — one that can end up offsetting any initial benefit, they say.

The danger, Israelov says, particularly pertains to individual investors who see the word “income” in a fund’s name and and envisage bumper profits. Unlike Treasury bonds whose coupon income is part of guaranteed money if held to maturity, harvesting yield from options is more nuanced.

To demonstrate the downside, the NDVR study focused on one strategy that sold out-of-the-money S&P 500 calls on a monthly basis and held them until expiration. (A call contract gives the buyer the right to purchase the underlying security at a specific price, or strike, up until a defined expiration date.) It designed trades targeting an annualized income yield ranging from 1.2% to 18%, and modeled their historic performance based on actual pricing data. 

Since 1999, the model has lost money almost across the entire target-yield spectrum because, on average, those call contracts were settled at higher prices than they were sold for. That means the seller needed to pay the differences to close the trades, resulting in losses. 

“Many investors may have been conditioned to believe that a portfolio’s income is sustainable over the long term without drawing down their principal,” the researchers wrote. “If an investor carries over such beliefs to covered call strategies, they might find themselves in trouble.”

Derivative-income funds are booming as investors crave steady returns at a time when the Federal Reserve’s battle against inflation has made both stock and bond performance less reliable. There have been almost 40 such products launched this year and a handful plan to debut soon, data compiled by Strategas Securities show.  

To be sure, there are many ways to harvest yield from derivatives trading, and many work just fine if deployed at the right time and at the right price. What the NDVR paper highlights is the risk of counting on the income as a reliable source of returns. 

In the simplest form, selling a call option amounts to a wager that the underlying asset will stay below the strike price. When stocks show a tendency to go up, call sellers naturally have the odds stacked against them.

Israelov noted that the firm’s model has seen performance deteriorate in the past decade, in part due to an unusually robust market rally. Since 2011, a trade targeting a 6% annual income yield is down 3.1% a year, compared with a 0.5% decline over the study’s entire history. 

He also observed that higher income-seeking strategies tended to suffer more losses. That’s partly because option-pricing mechanism is such that all else equal, in order to generate more income, the strike price must be set closer to the underlying security’s current levels. The closer the strike, the more likely the contract goes in the money and turns against the seller. 

“Many appear to be enamored by the strategy’s ability to deliver high derivative income,” Israelov said. “To the extent people associate high derivative income with high expected total returns, they have made a grave error.” 

©2023 Bloomberg L.P.