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yield hog

With bond and GIC interest rates shrinking to microscopic levels, income-hungry investors are snapping up yield products as fast as marketers can crank them out. Unfortunately, understanding how the products work or the risks involved are often secondary considerations.

With that in mind, today we'll look at covered call exchange-traded funds. Many of these complex ETFs sport high single-digit or even double-digit yields, but they also carry risks that the average investor may overlook, making them unsuitable for anyone requiring capital preservation or a stable source of income.

What are covered call options?

When an investor or ETF sells (or "writes") a covered call option, it gives the buyer the right to purchase their stock at a certain "strike" price. The seller is "covered" because he or she owns the stock, as opposed to a "naked" call in which the option seller doesn't own the stock.

The purpose of selling options is to earn premiums, and this extra income enhances the underlying yield of the fund, making those juicy payouts possible.

Here's a simplified example: Suppose you own a share of XYZ Corp., which trades at $50. You decide to sell a covered call option for $2, giving the buyer the right to buy your XYZ share for $51 at any time in the next month.

The $2 premium is yours to keep. If the price of the stock stays below the $51 strike price, the buyer would let the worthless option expire. If the price rises above $51, however, the holder would exercise the option and call the shares from you.

Limited upside

This brings us to the first drawback of a covered call strategy: It eliminates the potential upside of your stock beyond the strike price. If XYZ had soared to $60, for example, the option holder would get to buy your shares at the now bargain price of $51. All you'd get is $2 in premium income and $1 in capital gains. Clearly, you would have been better off not writing the option and just holding the stock.

Now, if you want to replenish your portfolio, you'll have to go out and buy the shares at the new, higher price. In practice, many funds will buy back the option before it is exercised so they can hang on to the shares. But because the option will also have risen in price, the net result is essentially the same.

Downside protection

Covered calls do provide a buffer in market downturns – to a point. If the stock fell to $48, you'd still break even thanks to the $2 in premium income. However, below $48, you'd lose a dollar for every dollar the stock fell.

Essentially, the option writer is trading the potential upside of the stock for a cash premium and a small amount of downside protection. This can work in the investor's favour in certain markets. However, it can also backfire.

Bear markets

Where covered call ETFs could stumble is following a market bloodbath, such as the 50-per-cent collapse in 2008 and 2009.

To keep the premium income rolling in, the ETF would have to write covered calls at sharply lower strike prices. If the market rebounded strongly, the ETF would lag because its gains would be capped.

"A covered call writing strategy works best in a range-bound volatile market," said David O'Leary, director of fund analysis with Morningstar Canada. "But in a bear market, for a portfolio that must continue to pay a consistent income, it's a recipe for disaster."

Generally, when a product is dangling a high yield in front of investors, it has to be taking on extra risk to generate that additional income, he said.

Slow but steady

The ideal backdrop for the covered call strategy is when the market is rising slowly but steadily, said Eden Rahim, portfolio manager and options strategist with Horizons Exchange Traded Funds Inc. In such cases, the option seller would collect premiums but the stocks wouldn't push through the strike levels.

Covered call ETFs should also outperform in slowly falling or sideways markets, but when stocks surge as they did following the 2008-09 collapse, the funds would underperform, he said. Another thing to keep in mind is that distributions aren't fixed; premium income will vary based on market volatility, which affects options prices.

"This is not for fixed-income or preferred share investors. It's not for investors who are looking for principal protection," Mr. Rahim said. "This is strictly for equity investors who want market exposure and are willing to exchange the low probability of sharp monthly gains for the high probability … of another form of income."

Investment industry veteran Peter Hodson, editor of Canadian MoneySaver magazine, agrees that covered call strategies have their place. However, he said risk-averse investors need not apply.

"You need to understand you're not eliminating equity risk here," he said. "You're not going to be immune to a market decline by any stretch."

To take one example, the covered call Horizons Enhanced Income Equity ETF – which holds an equal-weighted portfolio of 30 large-capitalization Canadian stocks – is down 10.2 per cent on a total return basis (including distributions) since inception on March 17. That's virtually identical to the total return of the iShares S&P/TSX 60 index fund over the same period.

Most of the new batch of covered call ETFs from Horizons and competitor Bank of Montreal have been around for less than a year, which makes it tough to judge their performance. That's one more reason investors should exercise caution.

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