In creating approved lists of ETFs that can be offered to retail clients, one common compliance practice is to prohibit funds that employ leverage. It’s a marketing challenge that two Toronto-based firms – Hamilton Capital Partners Inc. and Brompton Funds Ltd. – have faced in pitching their income-oriented leveraged ETFs.
Hamilton Enhanced Canadian Bank ETF (TSX: HCAL), launched in October 2020, and Hamilton Enhanced Multi-Sector Covered Call ETF (TSX: HDIV), launched last July, each employ 25% leverage. So does Hamilton Enhanced Canadian Financials ETF (TSX: HFIN), which debuted in January.
Employing 33% leverage is Brompton Flaherty & Crumrine Enhanced Investment Grade Preferred ETF (TSX: BEPR), a former closed-end fund that converted in November.
When HCAL launched, many brokerages “barred the fund from being traded because they just saw the word ‘leverage,’” said Rob Wessel, Hamilton’s co-founder and managing partner.
The firm sought to ensure that everybody who evaluated the product understood it was different from the extremely volatile BetaPro ETFs. Sponsored by Toronto-based Horizons ETFs Management (Canada) Inc., those funds employ leverage of up to 200% and are designed for very active short-term traders.
Conversely, “our modestly levered ETFs are for long-term investors,” Wessel said.
Brompton, meanwhile, has the marketing advantage of a long track record for its fund, which invests in U.S. preferred shares and has performance history dating back to December 2004. Though volatile for an income product, BEPR’s 10-year return is a near double-digit 9.7% as of Dec. 31.
“A lot of our marketing efforts have been focused on pre-existing holders,” said senior vice-president Chris Cullen, Brompton’s head of ETFs. “We have a group of [advisors] out there that has been very happy with the way (the former closed-end fund) and BEPR has performed for clients.”
Conversion to an ETF has allayed advisor concerns that the Brompton fund lacked liquidity. “If you put in a redemption and a creation mechanism, then all of a sudden you can get dealers to support your fund by quoting on very competitive spreads,” Cullen said. “You can’t get the same thing for closed-end funds.”
Leveraging magnifies price performance, for better or worse. The risk of employing leverage is lower if the underlying assets are less volatile than the broad market, and if these assets make income distributions. So it is with HCAL, which invests in Canada’s Big Six banks. HCAL tracks the total return of the Solactive Canadian Bank Mean Reversion index, which overweights the three “most oversold” bank stocks every quarter.
“HCAL’s volatility is not meaningfully different than the individual Canadian banks,” said Wessel. What is different is the ETF’s rich dividend yield, which at a recent 5.34% was 25% higher than that of the underlying stock portfolio.
The Brompton fund, which Cullen describes as Canada’s first leveraged fixed-income ETF, has a current distribution rate of 6.9%. That’s about two full percentage points higher than Brompton’s unleveraged preferred-share ETF.
The historic volatility of the Brompton leveraged ETF is close to, but still below that of a large-cap equity portfolio, Cullen said. “What we wanted to do was to boost income yield without making this into a high-risk investment.”
Retail investors can borrow on their own to invest in any securities they like, but at far higher retail rates. Currently, Brompton can borrow at rates below 1%, Cullen said.
That’s not to say that leveraging is cost-free. The management fee (not including expenses) of Brompton’s leveraged ETF is 1%, which is 25 basis points higher than its unleveraged equivalent. Hamilton’s leveraged bank ETF charges 0.65%, 20 basis points higher than its similar unleveraged ETF.
The Hamilton multi-sector ETF also charges a 0.65% management fee, but this doesn’t fully reflect the costs of ownership to investors. This ETF is an equally weighted portfolio of seven Toronto-listed sector ETFs that employ covered calls to generate premium income. Hamilton’s fee is in addition to the fees bundled into the underlying ETFs, which are on average about 69 basis points.
“We wanted to basically create a covered-call version of the S&P/TSX 60 but with modest leverage,” Wessel said. The underlying ETFs, combined with 25% leverage, currently generate a yield of 8.1%, more than triple that of the iShares S&P/TSX 60 Index ETF.
While covered calls limit growth potential, Hamilton’s strategy helps mitigate the tradeoff between higher income and lower capital gains. The 25% leverage is meant to provide the best of covered calls without the negative of underperformance in a rising market, Wessel said. And in a falling market, while leverage will steepen losses in securities prices, the income portion of the total return will continue to be enhanced.
The multiple rate hikes central banks in Canada and the U.S. are signalling this year will raise the cost of leverage. In the case of the Brompton ETF, which has similarities with bonds in terms of interest-rate sensitivity, higher rates could also translate into falling prices for preferred shares.
Cullen said the types of fixed income assets that would fare better in a rising rate environment are those with higher interest coupons and lower duration than the broad bond market, such as U.S. preferreds.
Since preferreds are subordinated credits in the event of a corporate default, investors receive higher yields to compensate. “You have a manageable duration and a high level of coupon to offset any negative price action,” Cullen said.
He added that the ETF, which is actively managed by California-based preferreds specialist Flaherty & Crumrine Inc., holds securities of high-quality issuers. ‘There’s been very little default activity in the preferred share market.”
Cullen said there’s a need within the advisor community to find high yielding and fairly safe vehicles. With a medium risk rating according to regulatory criteria, the leveraged Brompton ETF can “certainly can increase the yield available to clients in that diversified portfolio,” he said.