Canadian Covered Call ETFs

Last week I received a question from a reader on covered call ETFs:

“Just would like to hear other people’s views of the covered call ETFs from Horizons that are currently paying around 15%, such as HEX-T, or of BMO’s ZWB that is paying close to 10%.”

There have been several articles already written on covered call ETFs here in Canada, and I’ve listed some of them below. Since then, both BMO Financial Group and Horizons have added new covered call ETFs. While I have nothing new to offer to the debate, I do think investors are taking risk with their capital in exchange for a higher yield. Here are the basics of covered call ETFs, using ZWB as an example.

Investors Are Yield Hogs

“You can make a lot of money in the investment business by trying to help people defy the gravitational pull of low interest rates.” (Rob Carrick)

It’s no surprise that in this era of low interest rates and dismal returns on GICs investors have been flirting with higher yielding securities. Many have turned to the income from dividend-paying stocks, and even higher yielding companies such as REITs and the previous income trusts. But it hasn’t stopped there. Now covered call ETFs in Canada, are offering investors yields of 6.7% to more than 26%.

ZWB was the first covered call ETF introduced in Canada, launched on January 28th by BMO Financial Group. The Canadian Couch Potato covered the launch of ZWB in an earlier post, More Income ETFs from BMO.

Here are the covered call ETFs in Canada and their corresponding yields. You will notice that all these ETFs were launched only this year, with the latest from BMO introduced just this month:

ETF Ticker MER Yield Inception Date
BMO Covered Call Canadian Banks ETF ZWB 0.65 8.50% 28-Jan-11
BMO Covered Call DJIA Hedged to CAD ETF ZWA 0.65 6.76% 20-Oct-11
BMO Covered Call Utilities ETF ZWU 0.65 9.18% 20-Oct-11
Horizons AlphaPro Enhanced Income Energy ETF HEE 0.65 19.60% 11-Apr-11
Horizons AlphaPro Enhanced Income Equity ETF HEX 0.65 19.40% 11-Apr-11
Horizons AlphaPro Enhanced Income Financials ETF HEF 0.65 15.10% 11-Apr-11
Horizons AlphaPro Enhanced Income Gold Producers HEP 0.65 21.00% 11-Apr-11
Horizons AlphaPro Enhanced Income Intl Equity ETF HEJ 0.65 26.40% 14-Sep-11

What is a covered call?

In the financial industry, covered call options are considered quite conservative. In his post on How to Write Covered Call Options, Million Dollar Journey writes the following:

A covered call option is when you own the underlying security, and you sell the option for another investor to purchase at a specified price (strike price). The call option buyer pays the seller/writer a premium for the option to purchase the stock in the future.

So the covered call generates additional income from a security with an option premium.

The problem with covered calls is that if the underlying stock rises in value, the option will be exercised or “called away.” This requires the underlying stock to be sold at the strike price below the current market value. You will give up any subsequent gains as the stock price continues to rise.

However, if the stock never reaches the strike price, then the option will simply expire and you get to keep the premium. It’s this premium that adds additional income to the covered call. So a covered call works best in anything but a rising market.

How Covered Call ETFs Work

A covered call ETF applies this option-writing strategy to an underlying basket of securities. For example one of the most popular ETFs in Canada, BMO Covered Call Canadian Banks ETF (ZWB), invests in the big Six banks, and then writes covered calls on the underlying securities. It accomplishes this largely through owning 46% of its assets in BMO Equal Weight Banks ETF (ZEB).

The advantage of using a covered call strategy is the income generated from the premiums on the calls. This can be a whopping difference. For example ZEB offers a current yield of 4.29%, not bad at all for a basket of Canadian banks. But with the added covered call strategy, the yield increases to 9.39% – more than double the original yield.

Covered Calls Are Not For Bulls

The downside of covered call ETFs will become apparent in a rising market. If stock prices surge, then ZWB will lag behind the very stocks it owns, because the covered call options will be exercised. In a bull market, you would be better off holding ZEB instead of ZWB. Covered call ETFs make sense in a declining or sideways market for the added income, but you’ll lose out on the gains during a rising market.

Food For Thought:

Answer – The Pros:

  • High yields of 6.7% to more than 26%.
  • Some downside protection during a declining market (the option premiums offset some of the losses)
  • Distributions are paid monthly
  • The covered calls are handled by an expert

Answer – The Cons:

  • Covered call ETFs will lag in a rising or bull market
  • ETFs like ZWB are sector-specific, which adds additional risk
  • Past performance is not indicative of future results
  • The premiums generate capital gains which are taxable
  • The MERs are higher (active management and more trading fees)

The bottom line is, don’t overload your portfolio with these high yielding covered call ETFs, because they can become a double-edged sword. You will win on the downside compared to being invested in stocks without the call options. However you will give up the future gains in stock prices during a rising market.

Stick to your Indexing and/or Dividend Paying core, and if you must, add these covered call ETFs in small percentages for increased monthly income. As they say, there is no free lunch, so if you are getting a high yield you will pay for it somewhere down the line. In a guest post for Million Dollar Journey, the Intelligent Speculator writes:

Any product that promises extra returns or income has a downside. There is no alternative. In this case, the main downside is the limited gains when markets rise (especially if it happens quickly)… One thing stands true though, there is no free lunch and covered calls ETFs are no exception.

Other Articles:

Here are some other great posts on covered call ETFs in Canada:


Disclaimer:
I don’t own ZWB, HEX, or any other covered call ETFs, and I have no intention to buy any in the foreseeable future.

Readers, what are your thoughts? Do you own any of the covered call ETFs mentioned? Do you think they are worth adding to your portfolio?

17 Responses to “Canadian Covered Call ETFs”

  1. Anders

    Nov 04. 2011

    Andrew said it all, “nicely researched and objective.” I will also add extremely readable and understandable.

    It was also nice to be informed that BMO has the new covered call utility out.

    Keep up the great work!

  2. The Dividend Ninja

    Nov 04. 2011

    Andrew Thanks for dropping by, I know you have a busy shcedule! 🙂

    Anders Thanks as well!

    Cheers

  3. Henry Le

    Nov 04. 2011

    There seems to be an ETF for just about anything nowadays. I bet there’s one for selling naked put options.

  4. The Dividend Ninja

    Nov 04. 2011

    Henry I’ll just take the naked one 🙂

  5. My Own Advisor

    Nov 05. 2011

    Nice post Ninja!

    Never been a fan of these products, too much to think about about. I’m learning more and more, the best investment strategy is often the most simplistic. At least for me it is 🙂

  6. The Dividend Ninja

    Nov 05. 2011

    MOA I completely agree 🙂

  7. My Own Advisor

    Nov 06. 2011

    BTW – unrelated to this post, I mean to mention, your site looks awesome. Much cleaner and more streamlined.

    Easy to find stuff, easy to read, easy to visit 🙂

    Nicely, nicely done!

    OK, that’s it, for now 😉

  8. MoneyCone

    Nov 07. 2011

    Excellent coverage of Covered calls! Even though the post is focused on Canadian covered etfs, the explanation is universal!

  9. Summitman

    Feb 07. 2012

    Interesting take on the covered call ETFs. I actually own three of the Horizons covered calls and can’t argue with the dividends they pay.

    I guess my strategy is to hold a 25% core position of my portfolio with these (using DRIPs), and then focus another 25% portion on high-return junior resource stocks.

    The other fifty percentage is split between bond funds and blue chip stock ETFs spread across different sectors.

    My theory is that if the market continues to move sideways (as it has for the last decade in North America, or for the last two decades in Japan), then the covered calls should help to offset this stagnant growth with reinvested dividends. I basically see the covered calls as an insurance policy against the very real possibility of long-term stagnant growth in the overall stock markets.

    And if the market does move up, hopefully I’ve done a good job at stock picking in the junior resource sector. 🙂

    Anyway, that’s my two cents.

    • The Dividend Ninja

      Feb 07. 2012

      Summitman That’s an interesting portfolio! Potential for big gains, but also seems high risk on the downside. But your monthly income must be quite nice I don’t think I could invest in the junior resources stocks – just not in my risk profile. 😉

      Cheers

  10. Summitman

    Feb 07. 2012

    Interesting take on the covered call ETFs. I actually own three of the Horizons covered calls and can’t argue with the dividends they pay.

    I guess my strategy is to hold a 25% core position of my portfolio with these (using DRIPs), and then focus another 25% portion on high-return junior resource stocks.

    The other fifty percentage is split between bond funds and blue chip stock ETFs spread across different sectors.

    My theory is that if the market continues to move sideways (as it has for the last decade in North America, or for the last two decades in Japan), then the covered calls should help to offset this stagnant growth with reinvested dividends. I basically see the covered calls as an insurance policy against the very real possibility of long-term stagnant growth in the overall stock markets.

    And if the market does move up, hopefully I’ve done a good job at stock picking in the junior resource sector. 🙂

    Anyway, that’s my two cents.

    • The Dividend Ninja

      Feb 07. 2012

      Summitman That’s an interesting portfolio! Potential for big gains, but also seems high risk on the downside. But your monthly income must be quite nice I don’t think I could invest in the junior resources stocks – just not in my risk profile. 😉

      Cheers

  11. Summitman

    Feb 08. 2012

    Yes, the junior resource sector is probably the riskiest sector out there, but it depends on how you approach it. Primarily, it’s time consuming doing due diligence, because you definitely want to pick more of the right ones than the wrong ones.

    On the other hand, you can only ever lose 100% of your investment, while sometimes you can make 500% to 1000%.

    Generally, my strategy with these stocks is to buy as low as possible (rather than chase a fast-rising stock), sell half on the double to recoup principal, and then ride the rest until it becomes obvious what direction it’s going. Even under the horrid market conditions of last fall, there were two picks that managed to double. Some years, when the market is in a better mood, it’s not uncommon to have 80-90% of one’s picks double or better.

    Nevertheless, there will always be a few that you lose 100% of your investment on.

    Each to their own I guess. 🙂

  12. Summitman

    Feb 08. 2012

    Yes, the junior resource sector is probably the riskiest sector out there, but it depends on how you approach it. Primarily, it’s time consuming doing due diligence, because you definitely want to pick more of the right ones than the wrong ones.

    On the other hand, you can only ever lose 100% of your investment, while sometimes you can make 500% to 1000%.

    Generally, my strategy with these stocks is to buy as low as possible (rather than chase a fast-rising stock), sell half on the double to recoup principal, and then ride the rest until it becomes obvious what direction it’s going. Even under the horrid market conditions of last fall, there were two picks that managed to double. Some years, when the market is in a better mood, it’s not uncommon to have 80-90% of one’s picks double or better.

    Nevertheless, there will always be a few that you lose 100% of your investment on.

    Each to their own I guess. 🙂

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