Are you looking to combine small-cap upside with income? With markets seeing increased volatility and large-caps looking expensive, marrying the two could boost portfolios. Small-cap covered call ETFs can offer both small cap performance and some helpful income on the side. However, many such strategies have an important flaw for investors to keep in mind that limits how effective they can be.

See more: Tax-Loss Harvesting? Get More From Current Income in Daily Covered Call ETFs

Traditional covered call ETFs typically invest in stocks and sell options that expire on a monthly basis to generate high levels of income. By selling options on the stocks it owns, a covered call ETF can collect premiums. Combined with regular stock dividends, those premiums produce yields that often exceed bonds. That has helped covered calls grow significantly in popularity in recent years, with new covered call ETFs launching to meet that demand. 

Small-caps can be a particularly interesting segment for covered call strategies.  When they do well, small-caps can provide some strong growth for investor portfolios. And because they tend to be more volatile than large-caps, a small-cap covered call strategy can potentially provide higher income levels. That makes a powerful one-two punch. Many investors want diversification from their heavy exposure to large-caps. This is when small-cap covered calls carry an obvious appeal. 

Traditional covered-call strategies, however, face a tradeoff. In exchange for earning high levels of income, investors typically sacrifice a significant amount of total returns. Specifically, stocks rallying through the strike price of the sold option early in the month effectively cap its performance for the rest of the month. This tradeoff has proven especially costly in small-caps strategies, according to data gathered by ProShares. Investors look to small-caps for their significant growth potential. Given that, cutting off upside in the middle of a rally could really sting. 

A covered call strategy like the ProShares Russell 2000 High Income ETF (ITWO) is powered by a daily options strategy and can provide a solution. A daily options strategy effectively captures more of the market’s upside, thereby improving the tradeoff between income and total returns.  For those wanting that combination of income and small-cap performance, this strategy could have appeal. 

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