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Choppy markets have supercharged Canadians’ hunger for defensive, yet high-yield investments, and lately many are piling into a subset of exchange-traded funds that fit this bill – some with payouts around 13 per cent annually.

Covered-call funds have existed for some time, yet investor interest in them has soared over the past year. These products pulled in $4.2-billion worth of net inflows in Canada last year, according to research from CIBC World Markets, amounting to roughly 25 per cent of new money invested in the equity ETF sector.

The funds are hybrid ETFs that invest in a portfolio of stocks then layer on options to put a twist on the investment calculus. By writing call options they earn what is known as an option premium, similar to the premium on an insurance contract. These premiums are paid by a third party that gets the right to buy the stocks at a later date and they allow the funds to deliver enhanced yields.

If a stock in the portfolio 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. But if the stock rises above the predetermined price, the fund has to sell it to someone else so the investor loses the benefit of making more money as the share price rises.

Because of this dynamic investors won’t beat a hot market with these funds. Covered calls shine when the market is going sideways or is slightly negative.

The high yields on covered call funds have historically come from investing in dividend-paying stocks, which allows investors to capture both the regular dividend as well as the option premium. But the sector’s popularity is spawning new products and funds are getting experimental with their investment mix.

Some funds, for instance, are adding some leverage or debt in order to juice returns while others are expanding the range of sectors they will invest in. A newly launched fund, for instance, offers investors the chance to earn yield on growth stocks that don’t pay dividends, such as Tesla TSLA-Q.

While innovative, such funds do not have an extensive track record. Investors, then, do not yet have proof of how they will perform through different market cycles.

Investors also may not realize that funds with similar strategies can generate divergent returns. “Depending on the fund manager, option writing strategies can vary greatly and deliver different results,” CIBC World Markets analysts Jin Yan and Ian de Verteuil wrote in a recent report to clients.

The percentage of a 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.

The flipside, though, is that smaller percentages give investors more of the upside if the market climbs higher.

A new fund from Hamilton ETFs, one of Canada’s leading covered-call providers with more than $800-million managed in this category, illustrates how these strategies can differ. The Hamilton Canadian Financials Yield Maximizer ETF, known as HMAX, targets a payout yield of 13 per cent annually and it does so in part by writing options on 50 per cent of its holdings. (The fund invests in shares of Canada’s 10 largest financial services companies.)

“The essence of covered calls is that there is a yield-return trade-off,” Rob Wessel, Hamilton’s managing partner, said in an interview. When it comes to HMAX in particular, yield is the focus. If the Big Six banks have a strong rally, “you’re not going to keep up,” he said.

Bank of Montreal’s wealth-management arm manages the most covered-call assets in the country and one of its more popular products is the BMO Covered Call Canadian Banks ETF ZWB-T. Over the past five years, the fund has delivered a total return of 36.3 per cent, or 6.5 per cent annually.

However, BMO’s plain vanilla Equal Weight Banks Index ETF ZEB-T, which does not write any options, delivered a total return of 51 per cent, or 8.7 per cent annually, over the same period because Canada’s bank shares mostly rose during that window.

The yield on a covered-call fund is also affected by the volatility of the fund’s share prices. The more volatile a stock is, the higher its premium will be because there is a greater chance that it will rise above the predetermined contract price.

Such volatility can be mitigated by using a diverse portfolio of stocks. Purpose Investments, however, now offers high yield, single stock ETFs – a new concept for Canada, though one that already exists in the U.S.

Because Tesla’s share price is so volatile, Purpose is able to target a 15.6-per-cent yield on its covered-call fund that invests solely in the electric car company’s stock. Its equivalent fund that invests solely in shares of Google parent company Alphabet yields 10.5 per cent.

Recent market performance illustrates the trade-off that investors will have to accept if they really want these yields. Since the start of the year, Alphabet GOOGL-Q shares are up only six per cent, but Tesla’s stock is up 82 per cent.

The lesson, then, is that the yield-return trade-off can change depending on the sector. For growth companies, Purpose itself says it may be best to use single-stock ETFs to diversify a portfolio. These funds “should be used as a complement to holding the stocks directly,” Vlad Tasevski, Purpose’s chief operating officer, said in an interview.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 19/04/24 2:43pm EDT.

SymbolName% changeLast
TSLA-Q
Tesla Inc
-1.71%147.37
HMAX-T
Hamilton CDN Financial Yld Maximizer ETF
+0.59%13.58
ZWB-T
BMO Covered Call Canadian Banks ETF
+0.51%17.77
ZEB-T
BMO S&P TSX Equal Weight Banks Index ETF
+0.68%35.63
GOOGL-Q
Alphabet Cl A
-1.54%153.6

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