Look to covered-call ETFs for income

“There is an insatiable appetite for yield right now,” says Ken McCord, president of Horizons. “And investors can’t find it in traditional fixed-income investments such as [guaranteed investment certificates] or government bonds. Covered-call ETFs pay a healthy level of income and are tax-efficient — and that’s a home run for investors.”

The yield on covered-call ETFs is based on the dividends paid by the underlying securities, as well as on the income received by selling call options on those securities. Typically, the option premium income generates the lion’s share of the income. However, in a strongly rising market, covered-call ETFs will underperform a comparable but uncovered portfolio of stocks.

“If you buy into the notion that markets go up in the long term, selling covered calls cuts off participation in the upside,” says Dan Hallett, vice president and director of asset management with HighView Financial Group in Oakville, Ont. “The downside in a falling market is slightly cushioned by the options income, but that’s a fraction of the upside that could be missed in a rising market. In a nutshell, that’s the risk of these products.”

A call option is a contract that allows the purchaser of a stock option to buy the underlying stock at a specified price on a specified future date. If the stock’s price rises beyond the option’s strike (a.k.a. exercise) price within the time frame, the option purchaser will probably exercise the option and the stock will be “called away” from the ETF’s portfolio. The forced sale of the stock is the reason why the portfolio will lag in a rising market. The portfolio manager could avoid selling the stock by “repurchasing” the call option, but the option price would have risen along with the stock’s value and this also would hurt returns.

Alternatively, if the stock price falls below the strike price, there is no advantage to exercising the option, and the option’s purchaser will let the worthless option expire, leaving the ETF’s portfolio holding both the stock and the premium income received by writing the option.

The covered-call strategy works best in a range-bound or slightly falling market with some volatility, as volatility increases the premium income received through the sale of options. If the market drops by too much, however, the loss in the stock’s values will exceed any cushioning effect from the premium income received from the sale of the option.

“We sell away the benefit of upside participation for healthy options premium income,” says McCord. “Investors are starting to view volatility as an asset; it can be sold away for the price of the call options.”

Normally, options premiums are treated as income for tax purposes, but because of the ETF structure, most of the distributions are in the form of capital gains, which are taxed at half the rate of income. The premium income can be healthy, and that’s the appeal of covered-call ETFs. For example, BMO Covered Call Canadian Banks ETF has a current yield of 9.5%, more than double the 4% yield offered by the regular BMO S&P/TSX Equal Weight Banks Index ETF.

The BMO covered-call ETF has a slightly higher management fee, 65 basis points vs 55 bps for the regular ETF, due to the active component involved in managing the options strategy. In addition to this higher fee, the covered-call ETF also may have higher trading costs than the regular ETF because of the activity involved with managing the options strategy. The stocks are held in the covered-call ETF’s portfolio on an equal-weighted basis, so there is no active stock-picking.

The BMO covered-call ETF manages the risk of missing out on hot markets by selling call options on only half of the stocks in its portfolio, leaving the other half to participate in any stock market gains. But other product manufacturers use different strategies to enhance return. For example, Horizons is more aggressive and will sell call options on 100% of the stocks in its six covered-call ETF portfolios and two covered-call closed-end funds. And First Asset will write call options on only 25% of the stocks held in its family of six covered-call ETFs.

Horizon’s ETF family offers some of the highest yields, especially in its more volatile sector products. For example, Horizons Enhanced Income Energy ETF is listing an estimated annualized yield of 21.7%; Horizons Enhanced Income Gold Producers ETF has an estimated annualized yield of 24.9%; the broadly based Horizons Enhanced Income Equity ETF offers a smaller annual yield of 16.7%. Income is paid out on a monthly basis, but, McCord stresses, yield may fluctuate, and investors cannot count on having the same income every month or every year.

BMO’s strategy is more conservative. The goal is to create a steady and sustainable income, says Kevin Gopaul, vice president and chief investment officer, ETFs, with BMO. If market volatility falls and options premiums drop, BMO would have some flexibility in maintaining the distribution on its covered-call ETFs by writing calls on more than 50% of the stocks.

“We don’t want to set expectations for an unsustainably high yield,” Gopaul says, “or be forced to pay out a falsely high yield by dipping into the ETF’s capital.”

BMO Covered Call Canadian Banks ETF has been the most popular ETF in Canada this year, gathering $600 million in AUM since its February launch. Recently, BMO introduced BMO Covered Call Utilities ETF, providing exposure to a portfolio of Canadian utilities, telecommunications and pipelines; BMO Covered Call Dow Jones Industrial Average ETF (hedged to the Canadian dollar), provides exposure to the 30 U.S. blue-chip stocks that make up the DJIA.

First Asset introduced the covered-call strategy in Canada in a couple of its closed-end funds. First Asset has subsequently introduced its family of six covered-call ETFs through its subsidiary, XTF Capital Corp. These ETFs have garnered AUM of about $50 million and pay distributions quarterly rather than monthly. XTF’s latest offering is Tech Giants Covered Call ETF, a portfolio of the 25 largest technology companies in North America.

The covered-call strategy must be implemented on stocks that have an active options market, which means large, liquid names and few if any small-cap stocks. Covered-call ETFs are equities, with fluctuations in stock values and income, along with potential to offer enhanced yield.

“ETFs are evolving and creating new strategies all the time,”says Sandeep Gosal, senior analyst with Investor Economics Inc. in Toronto. “Covered-call ETFs are the latest example.” (For more on covered call ETFs, turn to  page 29).  IE