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Buildings on Bay Street in Canada's financial district in Toronto on March 18, 2020. Investment companies have been rushing to launch new versions of covered call ETFs as they've surged in popularity.Nathan Denette/The Canadian Press

Covered call exchange-traded funds that promise to pay as much as 15 per cent annually are some of Bay Street’s bestselling investment products this year, yet their underwhelming market performance raises questions about their value for investors.

Covered call funds are hybrid ETFs that typically invest in a portfolio of dividend-paying shares, while adding stock options to enhance their yields. The funds have been sold in Canada for more than a decade but they are taking on a new life this year because so many investors are searching for outsized monthly payouts now that many dividend stocks are paying yields no better than those offered by ultrasafe guaranteed investment certificates.

Since January, covered call funds have been the third-most popular ETF category in the country, according to TD Securities, attracting $3-billion in new assets. Their popularity has caught Bay Street’s attention, and lately investment companies have been rushing to launch new versions of these products, including covered call funds that invest in fixed-income ETFs or fixed-income securities.

But their returns aren’t always living up to the hype. Historically, investing in these funds came with a trade-off: Investors gave up the potential for stellar gains, in return for stability and protection. By design, covered call funds underperform in hot markets, and they should outperform in flat and negative markets because they pay higher yields than the dividend stocks they invest in.

That hasn’t been happening. Covered call funds have been underperforming in both flat and down markets. In other words, investors would have been better off owning the plain vanilla ETFs or stocks underlying the funds, which are often posting better returns and also cost much less in annual management fees.

This very scenario is something Dan Hallett, head of research at HighView Financial Group, has been warning could play out for some time. The problem, he fears, is that retail advisers and investors still don’t notice because they fixate on the promise of monthly yield.

“What irks me is the way they’re marketed,” he said of covered calls in an interview.

Fund companies tend to market these ETFs as a source of stable monthly income, which makes them sound like a fixed-income product. But they aren’t. Bonds pay stable income, and investors who buy them get their principal back at maturity. While covered call funds pay monthly distributions, the value of the money invested ebbs and flows with the market.

Mr. Hallett surmises that Canadian investors gloss over this fact because so many of the funds are defensive by nature, meaning they invest in stocks such as banks and utilities that are usually less volatile than those in other sectors.

“There has been, as long as I can remember, this infatuation with anything that pays out large amounts of cash on a regular basis,” he said.

Hamilton ETFs’ Canadian Financial Yield Maximizer fund, better known by its ticker HMAX, is one of the top-selling covered call funds this year and currently targets a 15.8-per-cent annual yield. The fund is designed to track the shares of 10 large financial services companies in Canada, including Royal Bank of Canada RY-T and Manulife Financial Corp. MFC-T, and it generates excess yield by offering options on a larger percentage of its portfolio than most covered call funds.

By writing call options, covered call funds earn what is known as an option premium, which is similar to the premium on an insurance contract. These premiums are paid by a third party, who gets the right to buy individual stocks in the portfolio at a later date. If a stock held by the fund stays below a predetermined price, the fund pockets the premium – the same way an auto insurer keeps monthly premiums when clients do not make accident claims. That helps to pay the enhanced yield.

But if the stock rises above the predetermined price, the fund has to sell it, meaning it loses the benefit of the gains as the share price rises. That drags down the overall performance of the fund.

The percentage of the portfolio that uses options is a key variable that changes from fund to fund. The smaller the percentage, such as writing options on only 10 per cent of the stocks, the less premium that is earned – and therefore the less extra yield paid out. In HMAX’s case, options are written on 50 per cent of the portfolio, which should enhance its yield.

Since launching in January with a 13-per-cent yield, HMAX has delivered a total return, after distributions, of negative-9.2 per cent, as of market close on Oct. 6 . That’s worse than the negative-7.4-per-cent total return generated by its underlying stocks over the same time period, after adjusting for their weightings in its portfolio.

Because these weightings change every month, exact comparisons are tough to generate, but the general theme of underperformance still holds, and it applies to other covered call funds. For instance, as of mid-September, Harvest ETFs’ Canadian Equity Income Leaders fund HLIF-T, which tracks 30 large dividend-paying stocks, delivered a total return of negative-2.3 per cent since launching in June, 2022, lower than the negative-1.9 per cent generated by its underlying portfolio.

Both of these funds have had relatively short lives so far, so it is possible they will outperform over the long run. Yet some covered call funds have been around for years and have been underperforming their underlying stocks in flat or down markets.

Bank of Montreal’s Covered Call Canadian Banks ETF, for instance, which trades under the ticker ZWB and has $2.7-billion in assets under management, has been trading for more than a decade and comprises a simple equal-weighted portfolio of Big Six bank stocks. Over the past five years this underlying portfolio has delivered a return, before dividends, of 3.1 per cent – the type of flat market in which covered calls should thrive.

But BMO’s covered call fund has delivered a total return of 14.1 per cent, including dividends over the past five years, as of market close on Friday, while the equal-weighted bank stocks have a delivered a total return of 26.6 per cent.

Asked about this in an interview, Chris Heakes, a portfolio manager in BMO’s ETF division, said that when it comes to covered calls, “flat needs an asterisk.” While the prices of equal-weighted banks are flat today compared with five years ago, “there are a lot of things under the hood.”

Early this year, for instance, the collapse of Silicon Valley Bank sent a chill through the banking sector, and stocks fell quickly. When such sudden moves happen, options strategies can struggle because options prices are highly susceptible to market volatility.

The same is true for the market crash, then recovery, when the COVID-19 pandemic first erupted. Stocks sold off quickly, then bounced back in a short period of time. Because of the way covered call funds deploy options, “after a COVID crash, we can’t recover as fast,” said Naseem Husain, a senior vice-president at Horizons ETFs, one of the leading covered call providers in Canada.

The reason why gets technical, but it has to do with the fact that rule that covered call returns cannot keep up when markets are rising. The options used in covered call contracts are often renewed every month, or bimonthly, and if there is a big market gain within this month or two-month window, investors won’t fully benefit from it.

The inverse, though, still holds: If there’s a big market drop in the same window, a covered call investor absorbs the full drop.

For some investors, particularly those in retirement or closer to it, these funds’ underperformance may not matter, because the monthly distributions trump all their needs. But for younger investors with a long time horizon, low-cost ETFs could be the better option – especially now that dividend stocks have sold off and many can be bought for cheap.

Follow Tim Kiladze on Twitter: @timkiladzeOpens in a new window

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