To enhance yields, three of the Canada's seven ETF providers, BMO, Horizons and First Asset, have a specialty group of funds that use covered call writing as a fundamental component of their investment strategy. In total, there are 20 ETFs available in Canada that generate income from option premiums. These covered call funds focus on equities and commodities, with total assets under management of $1.7-billion.
In the right environment, the premiums from writing covered calls can add an extra 50 per cent or more to an ETF's dividend income. The ideal environment involves high volatility, which results in a higher price for the calls being sold.
But high volatility is a double-edged sword. The more the price of the underlying stock moves, the greater the chance the options being sold end up in-the-money When this happens, the ETF must either deliver the underlying shares to the buyer of the call options, which requires the provider to replace the underlying shares in the ETF portfolio at the current / higher market price, or roll-over the options and incur additional costs.
Because covered calls cap the upside of the underlying stocks at the strike price of the options, this strategy does not make sense in a bull market. When stocks are running up, investors would be wiser to be buying calls, not selling them. In a bear market, the income from covered calls helps to offset a portion of the losses in the underlying portfolio, but ultimately it would make more sense to be invested in a sector that is not declining.
While high volatility is ideal for covered call pricing, the best market for the ETF is sluggish, one where the underlying stock prices move upwards but never exceed the strike price of the options.
Based on current trends, Canada's banking sector may find itself trapped in this type of trading pattern, potentially putting the sector in a unique position to be a perfect candidate for a covered call strategy.
Despite robust Q1 earnings and increases to dividend payouts, precariously high consumer debt levels and unsustainable housing prices have fuelled skepticism in the market, which could create a price ceiling for Canada's big bank stocks. For investors looking to continue to participate in the financial sector, shifting to a covered call strategy employed by one of these ETFs could be prudent.
BMO Covered Call Canadian Banks ETF
The largest covered call ETF, with more than $900-million in net assets, ZWB has an annualized yield of 6 per cent. The manager of the fund writes calls on 50-55 per cent of the portfolio, which exclusively holds the big six Canadian banks at essentially the same weights. On average, the strike prices of the calls are written three per cent out-of-the-money. Over the last twelve months, ZWB has delivered a total return of 12.6 per cent (as at Feb 28, 2013).
Horizons Enhanced Income Financials ETF
With $26.2-million of net assets, HEF has an annualized yield of 4.7 per cent. The manager writes calls on one hundred per cent of the portfolio, which consists of twelve stocks, a mix of life insurance companies and the big banks, held at close to equal weights. The total return over the last twelve months is 2.9 per cent.
First Asset Can-Financials Covered Call ETF
$9.2-million in net assets. Delivered a total return of 12.2 per cent over the last twelve months. The fund manager writes calls on approximately twenty-five per cent of the portfolio, which consists of twenty-five holdings, held at relatively equal weights, with the big banks making up 23.1 per cent of the total.
The other segment of the market that could find itself range bound and well suited for a covered call strategy is the broad U.S. market indices. With both the S&P 500 and the Dow Jones Industrial hovering around record highs, their rapid climb following the financial crisis might be hitting its peak. Rather than buying these indices outright, consider opting for one of the following ETFs that employ a covered call strategy:
BMO Covered Call DJIA CAD-Hedged ETF
With $85.8-million in net assets, ZWA has an annualized yield of 5.9 per cent and delivered a total return of 9.7 per cent over the last twelve months. The fund manager writes covered calls on each of the individual stocks that make up the Dow, which consists of thirty stocks that range in from 0.5 per cent to 10.5 per cent of the total. Because the Dow encompasses a wide range of stocks that have much different volatility levels, contracts vary from two per cent out-of-the-money, in the case of low Beta stocks like Johnson & Johnson, to as much as 8 per cent out-of-the-money for high Beta stocks like Bank of America.
Horizons Enhanced US Equity Income Fund
$20.6-million in assets under management with a 3.7 per cent annualized trailing yield. HES holds fifty large cap U.S. equities in its portfolios that represent a wide subsection of the market. HES is CAD-Hedged and pursues an Equal-Weight methodology.
Horizons Enhanced Income U.S. Equity (USD) ETF
$43.8-million in assets under management, a 4.4 per cent annualized yield and a total return of 6.4 per cent over the last twelve months. HEA is also an Equally Weighted ETF, but unlike HES, trades in USD.
Volatility levels going forward will have a big impact on the performance of these equity-based covered call ETFs. Currently, the indices that track volatility are trending towards multi-year lows and conceivably have reached a floor.
Another option for investors, which involves significantly higher volatility levels and consequently a much higher implied yield, is a commodity based covered call ETF.
Horizons Natural Gas Yield ETF
With a current yield clocking in at 19 per cent, HNY simply needs market prices and volatility levels to stay constant to outperform. HNY holds NYMEX natural gas future contracts for the next January delivery month, which are hedged back into Canadian dollars, and the fund manager writes call options on these future contracts. With $7.7-million in assets under management and a total return of 7.1 per cent over the last six months, the price outlook for natural gas going forward will be critical to determine before investing in this ETF. Arguably, natural gas prices may have bottomed out, which would greatly benefit future total returns.
Covered calls represent one of the few ways to enhance yields in a sideways market. It is important to note that income generated from option premiums is much less reliable than dividend payouts. Covered call income is extremely sensitive to volatility levels, which can change quickly and without warning. The strategy is maximized when cash flows are reinvested, allowing the NAV to grow, providing the ability to write more calls. These dynamics make covered call ETFs more suitable as a complementary strategy to the core of a portfolio.
ETFinsight is a website dedicated to helping Canadians connect with relevant ETF solutions. Read more at www.etfinsight.ca, follow us on Twitter@etfinsight and Josh Erhlich can be contacted at: firstname.lastname@example.org