Be wary of covered-call ETFs

Generally, all covered-call ETFs follow the same strategy. Effectively, the portfolio manager is writing out-of-the-money covered calls against all, or most, of the portfolio. In cases in which the stocks rise above the strike price, managers will generally take action to retain the shares.

For example, Eden Rahim, portfolio manager for Toronto-based Horizons Exchange Traded Funds Inc.’s family of covered-call ETFs, typically repurchases the short calls and then “rolls up” (i.e., sells at a higher strike price) and “rolls out” (i.e., sells calls that expire further out).

This seems appropriate, but there are challenges. The first is that portfolio managers can employ only the covered-call strategy. That tends to restrict the manager’s ability to use other active or alpha-generating approaches, such as spreads or put writing. This means that the number of tools available to manage risk within the portfolio are limited by the ETF’s prospectus.

Another challenge is that these ETFs typically distribute all the options premiums and dividends to the unitholders. One of the trade-offs in covered-call writing is that the premium received caps your upside in exchange for lowering your cost base, effectively reducing the downside risk on the underlying security. There is no downside risk reduction within the ETF if the entire premium is paid to the unitholders.

Thus, the price (net asset value) for each covered-call ETF reflects the market value of the underlying portfolio. And because these are equities-based ETFs that will rise or fall with the market (in the case of broad-based, diversified covered-call ETFs) or the sector in which the ETF is trading (i.e., the prices of gold, financials, utilities or energy ETFs will generally rise or fall based on the performance of the stocks in the underlying sector).

The other issue relates to the strategy itself — particularly within the broadly based covered-call ETFs, in which “reversion to the mean” plays a central role. In other words, when you write call options against all stocks in a well-diversified portfolio, over time, you will lose your best-performing stocks (i.e., they would be “called” away) but retain your dogs. This is less of an issue for sector-based covered-call ETFs because all stocks within a sector tend to move in the same direction at the same time.

Within broadly based diversified ETFs, reversion to the mean plays a central role because it implies over time that the dogs (i.e., the sectors that have underperformed) eventually have their day in the sun.

The challenge in the covered-call ETF is that the prospectus requirement of constantly having to write covered calls limits the dogs’ ability to recover. In other words, the portfolio manager can end up selling the dogs or rolling his position “up” and “out” on the dogs. Either strategy effectively translates into selling stocks at prices below what was paid for them.

Your clients can deal with this problem by: (1) understanding how the cash-flow distribution affects the ETF’s NAV; and (2) by implementing strategies that counteract the portfolio manager’s limitations as a result of the cash-flow distribution.

To that end, consider the following: look at the distribution history of the covered-call ETFs, and you can see that the yield can be in the high double digits. This reflects the distribution of the premiums and dividends, most of which are driven by the volatility inherent in the specific stocks in the portfolio.

You can also see it first-hand, as the NAV of many of the covered-call ETFs have declined since they were launched. That reflects the portfolio impact of the sector or market in which an ETF is investing.

As the portfolio manager of the ETF is limited in his ability to manage downside risk, you might recommend to your clients that they take matters into their own hands.

For example, they can use dividend reinvestment plans to mitigate the decline in their ETF’s NAV. In other words, rather than taking the entire distribution and using it as income, they can reinvest 50% of it back into the ETF.

Most important, you will want to make sure you match any recommendation to your clients’ objectives and risk tolerances. (Clients should be willing to hold equities, which implies a bullish bias.)

Conservative investors seeking income should tread carefully in this space. Certainly, covered-call ETFs can be one strategy to consider, given the tax advantages associated with the distributions. But conservative, income-oriented investors should be mindful of the aforementioned caveat of reinvesting a minimum 50% of the total distributions.

Even then, your clients should be prepared for some downside in the NAV, taking comfort in the fact that distribution reinvestment allows them to lower the investment’s cost base over time. IE