Redefining derivative income investing: How TCAL's active, lower-risk approach stands out from peers

Derivative income ETFs have garnered significant interest in the marketplace in recent years, attracting a number of participants with widely varying approaches to the goal of generating current income. In 2025, the Capital Appreciation Premium Income ETF (TCAL) marked T. Rowe Price’s entry into the category. Helmed by an award-winning portfolio manager² supported by a team with years of experience implementing covered-call writing, TCAL offers investors a compelling new choice that stands out from its peers.

Higher income from individual stock calls

Some of the funds in the Morningstar U.S. Derivative Income category consist of a portfolio that is long the S&P 500 Index and a call position written against the entire benchmark achieved through an equity-linked note (ELN) or through S&P 500 Index call options. We believe this approach of overwriting the entire benchmark is operationally simpler but ultimately inferior. This differs materially from how we implement our covered call strategy, and for important reasons.

Since the S&P 500 is a diversified index, volatility is inherently dampened relative to a single stock. A covered call strategy on the entire benchmark will result in a lower implied volatility for the corresponding at-the-money call option, and therefore a lower premium. Conversely, writing individual stock call options against each holding in a basket of equities, which will naturally have a higher implied volatility, nets us a relatively higher premium that can contribute to higher income payments.

Our approach also allows us to dynamically adapt to changes in volatility. When market volatility increases, we can write specific call options with strike prices for select positions that are further out of the money, which increases the potential upside we can participate in when markets recover, while maintaining our goal of delivering high income. Covered call positions implemented against a broad benchmark do not offer this tactical and dynamic investment process.

Lower risk by design

Fundamental research and active stock selection are at the heart of our process. Our research has demonstrated that risk-adjusted returns were better for calls written against lower-risk stocks than for higher-risk stocks. Consider TCAL’s exposure to the Magnificent Seven compared with the S&P 500 Index.

Stocks in this group may be favored for their growth potential, and while this is attractive in some contexts, we see it as significantly less so in a covered call strategy. When calls are written on a higher-risk stock, the ability to participate in the stock’s upside is significantly capped, while all of the downside in the stock is retained. In a covered call strategy, these stocks have tended to produce some of the worst risk-adjusted returns.

Moreover, we believe we are better able to manage risk by writing calls on each stock held by the fund, as our call option positions match our long positions. In a portfolio that implements call positions on a broad benchmark but holds a customized stock portfolio with weights and exposures that differ from the benchmark, that misalignment can significantly contribute to risk.

No counterparty risk

The ELN approach to derivative income taken by some of our peers also introduces counterparty risk in a way that may not be fully appreciated in the marketplace. ELNs have principal and income components, with returns linked to the performance of a specific stock or index. As with other fixed income instruments, ELNs have an issuer, such as a bank or other financial institution. Whether through broader instability or idiosyncratic challenges, the issuer of an ELN could become insolvent or otherwise unable to make payments on its issues. We saw this occur during the global financial crisis in 2008 and the U.S. banking crisis and collapse of Credit Suisse in 2023. If instability affected the solvency of an ELN issuer, the holders of these notes would be adversely impacted.

"...we believe the opportunity to maximize yield and avoid meaningful tail risks is the better approach."

On the other hand, TCAL’s process of writing covered calls on individual stocks through the use of listed options allows us to capture premiums at the time the contract is written. TCAL is not subject to counterparty risk, and we think this is a material difference between the fund and some other category constituents. While this is operationally more complex, we believe the opportunity to maximize yield and avoid meaningful tail risks is the better approach.