What is your opinion of covered-call exchange-traded funds? They have higher yields than regular ETFs but I’m wondering if there are any hidden risks.
Covered-call ETFs generate income by selling call options on a portion of their shares. Call options give the buyer the right to purchase a stock at a specified price before a certain date. (They’re known as “covered” calls because the ETF owns the stocks on which the options contracts are written.) The premium income from selling options allows the ETF to enhance the distribution paid to unitholders.
In some cases, selling call options works to the ETF’s advantage. When the underlying stocks are stable or fall in price, the option buyer has no incentive to exercise the option and the ETF simply pockets the premium. That’s why covered-call ETFs perform best, relative to plain-vanilla ETFs, in flat or falling markets.
However, in rising markets, covered-call ETFs typically underperform. When a stock rises above the “strike price” of the option, the option holder will exercise the option to buy the stock. The ETF still gets to keep the premium, but it suffers a loss on the stock, which it is forced to sell at a price below the market.
In effect, when you purchase a covered-call ETF, you’re giving up potential future gains in exchange for receiving slightly more income now. What’s more, covered-call ETFs typically have higher costs than regular ETFs, which exerts a further drag on performance.
Let’s look at an example. The BMO Covered Call Canadian Banks ETF (ZWB) yields about 6.6 per cent and charges a management expense ratio of 0.71 per cent. Year-to-date through Sept. 30 – a period when the coronavirus hammered bank stocks – ZWB posted a total return, including dividends, of negative 10.82 per cent.
Now let’s compare ZWB with the plain-vanilla BMO Equal Weight Banks Index ETF (ZEB), which yields about 4.9 per cent and has an MER of 0.61 per cent. Through Sept. 30, ZEB posted a total return, including dividends, of negative 11.5 per cent.
So, during the volatile market of 2020, the covered-call strategy generated a slightly better – or, at least, less bad – return. ZWB also slightly outperformed ZEB in 2018, which was also a bad year for bank stocks.
But in years when bank stocks did well, ZWB consistently trailed ZEB. In 2019, for instance, ZWB posted a total return of 14.27 per cent, compared with 16.03 per cent for ZEB. ZWB’s underperformance was even more dramatic in 2017 and 2016, when it lagged ZEB by 2.71 percentage points and 5.5 percentage points, respectively.
Could this be a fluke? Not likely. I compared the BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF (ZWA) with the BMO Dow Jones Industrial Average Hedged to CAD Index ETF (ZDJ). For the five years to Sept. 30, ZWA posted an annualized return of 9.62 per cent, well below ZDJ’s return of 11.88 per cent.
Remember, too, that the stock market tends to rise over time. That means there will be more periods when the covered-call strategy hurts performance than when it adds value.
Bottom line: If you’re tempted by the high yields of covered-call ETFs, remember that there is no free lunch with investing. You’ll likely pay for that fatter yield with lower overall returns.
I started looking at dividend stocks because guaranteed investment certificates pay next to nothing. I understand that you hold stocks and reinvest the dividends, but do you ever sell them? For instance, I own Algonquin Power & Utilities Corp. (AQN) and Bank of Montreal (BMO), which are up about 28 per cent and 33 per cent, respectively, since I bought them. Given that much upswing, wouldn’t it be better to sell and take the large gain and then get back in again at a lower price (cross fingers) in four, six or eight months' time? It seems strange to not grab this big increase as it represents many years of dividend value.
I occasionally sell stocks, but only when the business has taken a fundamental turn for the worse. For the vast majority of stocks I own, I buy and hold and don’t try to sell at one price and get back in at a lower price, which is what you are suggesting.
If you knew that Algonquin Power was going to fall 10 per cent or 20 per cent over the next few months, then selling now and buying back later would make perfect sense. But you don’t know that. Nor do you know that Bank of Montreal – which is already down more than 20 per cent from its January high – will fall further. What if you’re wrong and both stocks rise?
You seem to be motivated by a desire to protect your unrealized gains, but the prices you paid for AQN and BMO are irrelevant. That’s history.
The only question you should be asking now is whether you like the future prospects of these companies enough to continue to hold them. Instead of trying to guess where AQN and BMO will be trading in five months, think about where they will be in five years. Both companies have a long history of growing their earnings and dividends and, while the coronavirus has created short-term uncertainty, as an owner of both stocks I suggest that you focus on the long term instead of engaging in a short-term trading strategy that may or may not work out.
E-mail your questions to firstname.lastname@example.org. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.
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