Investors’ search for income in the current low interest rate environment has given rise to the creation of a growing number of exchange-traded funds (ETFs) that focus on income generation.
Although some of these income ETFs offer returns based on broad bond indices, others use a variety of more complex and diversified strategies to create or enhance income, such as put and call options, interest rate hedging and swaps, and various customized index- and equities-based strategies.
The more traditional ETFs replicate different bond indices or invest directly in portfolios of fixed-income securities such as high-yield and floating-rate instruments, dividend-paying equities and real estate investment trusts (REITs). Other ETFs also may use various portfolio-construction methods, such as laddered bond maturities and barbell strategies that combine short- and long-term bonds, to achieve their objectives.
As with ETFs in general, income-focused ETFs are available in actively and passively managed varieties. With active management, the portfolio manager isn’t confined to trading issues in similar proportions to the underlying benchmark, says Mark Noble, senior vice president, sales strategy, at Horizons ETFs Management (Canada) Inc. in Toronto. In contrast, index-based ETFs are required to hold the securities that are in the index and in the same proportions, although some ETF index strategies do have minimum liquidity thresholds and focus on a subset of securities that have adequate liquidity and can be traded easily, he notes.
Each income-generating strategy has its own risks and rewards. But the benefit that ETFs offer investors is broad product choice and the ability to diversify across various sources of income, says Pat Chiefalo, managing director of iShares Canadian product at BlackRock Asset Management Canada Ltd. in Toronto.
For investors seeking more passive income-generation strategies, BlackRock Canada offers a suite of dividend and strategic income ETFs. Chiefalo says the dividend suite, which includes products such as iShares Core S&P/TSX Composite High Dividend Index ETF and iShares Diversified Monthly Income ETF, is built on the premise that dividends historically have represented almost 40% of total global equities’ returns over the past 25 years.
iShares’ strategic fixed-income suite, on the other hand, focuses on controlling three key risks – duration, credit and overall portfolio risk, says Chiefalo. Among the ETFs in this suite are iShares Short Term Strategic Fixed Income and iShares Conservative Short Term Strategic Fixed Income.
Toronto-based First Asset Investment Management Inc., a wholly-owned subsidiary of CI Financial Corp., offers a family of actively managed income ETFs, says Rohit Mehta, executive vice president, distribution and strategy. They include First Asset Canadian REIT ETF and First Asset Active Credit ETF. The REIT ETF invests in an actively managed portfolio of real estate and related securities, while the Active Credit ETF invests primarily in high-yield bonds and floating-rate securities of low duration.
There is growing number of active portfolio management stategies designed to enhance returns, says Alfred Lee, vice president, global structured investments, ETFs, and portfolio manager with BMO Global Asset Management Inc. in Toronto. These strategies include the use of covered call and put options, credit derivatives and interest rate hedging to enhance income, and are offered by several ETF providers.
For example, BMO Covered Call Canadian Banks ETF writes covered call options on about half of its portfolio of Canadian bank stocks, and this ETF earns the underlying dividend from the stocks as well as premiums from writing calls.
BMO Floating Rate High Yield ETF invests in Canadian T-bills but uses credit derivatives to gain exposure to a diversified basket of higher-yield, non-investment-grade, floating-rate U.S. bond issues.
Using a different strategy, BMO US Put Write ETF writes put options on an underlying portfolio of U.S. large-cap equities. This ETF does not own the securities, but uses cash as collateral and collects premiums from the put options. “The return profile is uncorrelated to bonds and stocks,” says Lee.
Horizons offers a range of actively managed covered call ETFs to enhance income, with commodities, equities or fixed-income instruments as underlying assets. Covered calls may be written on 50%-100% of equities assets, but on only 33% of commodity assets, says Noble.
For example, Horizons Natural Gas Yield ETF provides exposure to the price of natural gas futures hedged to the Canadian dollar. Horizons Enhanced Income Energy ETF, another commodity ETF but with a broader focus, provides exposure to the performance of a portfolio of Canadian companies equally weighted in the crude oil and natural gas industries.
Another strategy is to use a proprietary model, says Vlad Tasevski, vice president of Toronto-based Purpose Investments Inc. For example, Purpose Premium Yield ETF employs a proprietary model to select securities rather than following a broad benchmark index, then uses both puts and covered calls to enhance yield.
© 2016 Investment Executive. All rights reserved.