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:
|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.
Here are some other great posts on covered call ETFs in Canada:
- Million Dollar Journey – How to Write covered call Options…
- Million Dollar Journey – Covered Call ETFs – HEX and ZWB
- Million Dollar Journey – Covered Call ETF Flaws (guest post)
- Canadian Couch Potato – More Income ETFs from BMO
- Rob Carrick – Covered Call ETFs: Approach with Caution
- Canadian Capitalist – An Introduction to Covered Call ETFs
- Canadian Capitalist – Past Performance of the CBOE S&P 500…
- The Dividend Guy – Covered Call ETF High Income, Low Risk?
- Covered Call ETFs – Enhanced Income from Index Investing
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?