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(Ece Savas/Getty Images/iStockphoto)
(Ece Savas/Getty Images/iStockphoto)

PORTFOLIO STRATEGY

The case against covered call ETFs Add to ...

The selection of exchange-traded funds is so vast today that the biggest favour you can do investors is to help them narrow down the choices.

So try this: Skip covered call ETFs.

There are some pluses to these ETFs, but the negatives are bigger. If you want investment income, look to plain old dividend and diversified income funds instead.

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It’s the limited yields available from products like these that led to the creation of covered call ETFs. The managers of these funds buy stocks and sell call options that allow other investors to purchase the shares at a pre-set price. Selling call options helps produce a flow of income yielding anywhere from 5 to 13 per cent, which beats the typical blue-chip income stock or ETF.

Covered call ETFs first appeared in early 2011 and, according to ETFinsight.ca, there are now 18 of them with combined assets of $1.9-billion, or 2.8 per cent of the total $67-billion that Canadians have invested in ETFs of all types.

ETF analysts say covered call ETFs are a cost-efficient alternative to running your own covered call strategy. But are they something everyday investors need in their portfolios? “The ETF providers might hate me, but I would say no,” said John Gabriel, an ETF strategist with the independent analysis firm Morningstar.

Covered call ETFs are supposed to provide a rich flow of income while offering modest share price appreciation and a cushion in down markets that should reduce losses in comparison to owning conventional ETF or individual stocks. “They’re a trade-off – you take a little extra income, but you cap your upside,” Mr. Gabriel said.

Volatile, directionless stock markets are ideal for covered call ETFs. We’ve had surging markets with low levels of volatility in the past couple of years, which means these funds have not been in their element. This helps explain the sometimes disappointing results investors have had from these funds so far, when compared to conventional investments.

Mr. Gabriel has compared the biggest of the TSX-listed covered call ETFs, the $954-million BMO Covered Call Canadian Banks ETF (ZWB), against a comparable conventional fund, the $623-million BMO S&P/TSX Equal Weight Banks Index ETF (ZEB). There’s a clear yield advantage for ZWB here – its yield came in a tick below 5 per cent at midweek, compared to 3.1 per cent for ZEB.

You get a somewhat different view when you consider total returns, or income paid out by an ETF plus changes in its unit price. ZEB’s annualized total return for the three years to April 30 was 10.5 per cent, and it made 24.6 per cent in the past 12 months. ZWB’s three-year return is just under 9 per cent, and its one-year return was 20 per cent. Income-seeking investors did get a higher yield with ZWB, but in a total-return sense they were worse off than investors who simply owned bank stocks via ZEB.

Chris McHaney, vice-president and portfolio manager at BMO Asset Management, said covered call ETFs are not designed to outperform conventional ETFs, especially in a fast-rising market. He sees these ETFs as being something to consider “if you’re an investor who is looking for tax-efficient current income with some growth potential, or who wants some equity exposure but not the full volatility of the market.”

Something else you get with covered call ETFs are high fees. Management expense ratios are comparatively expensive with these funds, but it’s the separate and often-overlooked trading expense ratio, or TER, that stands out. TERs show you the cost of securities trading by a fund’s managers – with covered call ETFs, these costs can be huge.

Data from ETFinsight.ca shows the TER for the most popular covered call ETFs range from 0.18 per cent to 1.24 per cent. “The trading expense ratio takes you away from the whole zone where ETFs are extremely cost competitive products,” said Yves Rebetez, managing director and editor of ETFinsight.ca. “Covered call ETFs are price-competitive versus you and I using covered calls on our own – not versus traditional ETFs.”

Mr. Rebetez notes that covered call ETFs vary widely in how they’re managed. He said that some of these funds have covered calls written on 100 per cent of the portfolio, others on roughly 50 per cent and some as low as 25 per cent. These are key details because lower levels of covered call writing leave an opportunity for capital gains as well as income, while higher levels put the emphasis on income.

How easy is it for retail investors to find and understand this information? “ETF fact sheets sometimes get into it, barely,” said Morningstar’s Mr. Gabriel. “But you have to stretch and look into the supplementary material. I don’t know how many investors do that.”

One of the good things about covered call ETFs is that the monthly income payments are tax-friendly. Some of the distribution per unit will usually be classified as eligible dividends, which benefit from the dividend tax credit in non-registered accounts. But here’s the downside: The rest of the payouts will likely be a return of capital, which could be problematic for some investors.

The vast majority of conventional dividend and income ETFs have a return of capital component in their distributions, too. But it’s more pronounced with covered call funds. For example, ZWB’s total distributions per share in 2013 came in at 84 cents, of which 36 cents was a return of capital and 48 cents was eligible dividends. With ZEB, just 4 cents of the total 2013 distribution of 68 cents was a return of capital.

A return of capital – basically, it’s like getting back a little of your upfront investment – is not taxed in the year you receive it. However, it does lower the adjusted cost base for an investment and thus increase the potential capital gain on sale. Some investors object to this, preferring to receive income from dividends and bond interest rather than a return of their own money.

Covered call ETFs are one of the investment industry’s more creative responses to investor frustration over low interest rates. There’s a case to be made for owning them, but I don’t buy it.

Globe App users click here for a selected list of covered call ETFs

Covered Call ETFs Uncovered

Here’s a look at the returns and fees of some of the largest covered call exchange-traded funds, which have been popular with income-seeking investors. MER means management expense ratio, which is a measure of almost all the costs associated with owning a conventional ETF except trading expenses. For those, there’s the TER, or trading expense ratio. Data are to the end of April.

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