The yields on covered call exchange-traded funds look very tempting. Is there a catch?
There’s almost always a catch when an investment seems too good to be true. Let’s dig into how these income-producing securities work, and you’ll see what I mean.
Typically, the yield on covered call ETFs is anywhere from 4 to 7 per cent, which is substantially higher than the S&P/TSX composite’s current yield of about 2.7 per cent. The fat yields have made these products popular with income-seeking investors, who can now choose from about 18 covered call ETFs in Canada.
But if more people understood how covered call ETFs generate that extra yield, they might not be so keen on them. The truth is that investors are sacrificing potential gains, and often paying hefty fees, in exchange for putting more income in their pockets.
Covered call ETFs sell (or “write”) call options on a portion of their underlying securities. They’re known as “covered” calls because the ETF owns the stocks on which the contracts are written. A call option gives the buyer the right to purchase the shares at a specified price before a specified date.
When an ETF sells a call option, it collects a premium from the option buyer, and it’s these premiums that allow the fund to pay out additional income. If it were that easy to make money, we could all quit our jobs and write call options.
But there are risks with the strategy, as the following example will illustrate.
Say you buy a share of ABC Corp. for $50. You’re keen to collect some extra income, so you write a covered call option on your share for $3. Let’s assume the option gives the buyer the right to purchase your ABC share, before a specified date, for $52.
You’re happy because you get to pocket the $3 option premium, and you still own the shares. As long as the price of ABC doesn’t rise above the $52 “strike price,” the option buyer won’t call away your share because he can buy it on the open market at a lower price.
So far, this looks like easy money.
But what happens if the market price of ABC rises to, say, $58? The option holder would then exercise his right to buy the share from you for $52, because now he’s getting a good deal. In this case, your total profit would be $5 – $3 from the premium, and $2 in capital gains – for a return of 10 per cent.
That seems pretty good, you think. And it is – until you compare it with the return you would have made if you hadn’t written the option. In that case, the $8 capital gain would have been all yours, for a return of 16 per cent.
Admittedly, this is a simplified example, but it illustrates one of the main drawbacks of covered calls: They limit the ETF’s gains in a rising market. In exchange for receiving cash now, you give up potential upside later. Since the stock market generally rises over time, this can be a lousy trade-off.
Consider the BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF (ZWA-TSX), which yields 4.5 per cent. Since this ETF was launched on Oct. 20, 2011, it has posted an annualized total return of about 14 per cent, including reinvested dividends.
Compare that with the BMO Dow Jones Industrial Average Hedged to CAD ETF (ZDJ-TSX), which does not use covered calls and yields 1.7 per cent. Its annualized total return over the same period was nearly four percentage points higher, at 17.9 per cent, according to Bloomberg. Clearly, writing covered calls while the Dow was surging over the past few years wasn’t such a great idea.
Another problem with covered call funds is their high fees. The covered call version of the BMO Dow Jones Industrial Average ETF has a management expense ratio of 0.74 per cent; the plan-vanilla version’s MER is just 0.26 per cent. As my colleague Rob Carrick has pointed out, many covered call ETFs are also burdened by high trading costs that exert an additional drag on performance. Trading costs aren’t included in the MER but are broken out separately in the trading expense ratio, or TER.
I don’t mean to pick on BMO. Covered call funds from other ETF providers have also underperformed. For instance, the First Asset Can-60 Covered Call ETF posted an annualized total return – including dividends – of about 4 per cent for the three years ended June 30, compared with 7.4 per cent for the S&P/TSX 60 total return index.
Advocates of covered call funds argue that they perform best in sideways or falling markets, and that’s true – to a degree. If a stock tumbles, the strategy provides a buffer against losses, but only to the extent of the premium collected. Moreover, to keep premium income flowing in, the ETF will then have to write calls at lower strike prices, which again limits the upside if the shares rebound.
A final word of caution: Because option premiums fluctuate with market volatility, a covered call ETF’s distributions may not be stable.
Covered call ETFs may seem like a great idea for income investors, but I’ll stick with regular dividend stocks and ETFs, thanks.