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investor clinic

In last week’s column on dividend exchange-traded funds, I’m curious why you did not include any covered-call ETFs, which have much higher yields than the funds you profiled. For example, the BMO Covered Call Canadian Banks ETF (ZWB) and BMO Canadian High Dividend Covered Call ETF (ZWC) both yield more than 7 per cent, and the BMO Covered Call Utilities ETF (ZWU) yields more than 8 per cent. Why leave those out?

The financial industry knows that retail investors love nothing more than a juicy yield, which is why covered-call funds from ETF providers such as Bank of Montreal, Horizons ETFs and Hamilton ETFs have attracted billions of dollars in capital. But before you take the plunge with these high-yielding products, you need to understand how they work and the risks involved.

Like dividend ETFs, covered-call ETFs typically invest in a basket of stocks. But, unlike regular dividend ETFs, covered-call ETFs use an options strategy to generate additional income. As we’ll see, the higher yields of covered-call ETFs are not a free lunch.

When an ETF sells or “writes” a covered call option on one of its stocks, the buyer of the option gets the right to purchase the stock at a specified price by a certain date. The option buyer pays a “premium” to the ETF for this privilege. (It’s called a “covered” call option because the ETF owns the securities on which it is writing the option, unlike a “naked” call in which the option seller does not own the securities.)

What happens next depends on the price action of the stock in question. If the stock price remains roughly the same or falls, the option buyer will have no incentive to exercise the call option, which will expire. The ETF will pocket its premium and hold on to the stock. That’s why covered-call ETFs generally perform best in flat or falling markets.

However, if the stock price rises sharply, the option holder will “call” away the shares at the now lower-than-market “strike” price and realize a profit. The ETF will still get to keep the premium, but it will have to hand over the shares at a price that is lower than the current market price. This is a simplification of how the options market works, but the essential point here is that selling covered calls can be a losing strategy in rising markets.

Therein lies the problem with selling covered calls. They put money in the ETF’s pocket now – allowing it to distribute more cash to unitholders – in exchange for sacrificing capital gains later.

Moreover, covered-call ETFs typically charge higher costs than plain-vanilla dividend ETFs. The three BMO covered-call ETFs mentioned above each have management expense ratios of 0.71 per cent or more, which is nearly double the average MER of 0.38 per cent for the five dividend ETFs I discussed last week.

As you might expect, these higher costs, combined with the impact of having stocks called away in a rising market, can be a drag on the long-term returns of covered-call ETFs.

For the five years ended Sept. 30, ZWB, ZWC and ZWU posted annualized total returns (including dividends) of about 5.2 per cent, 3.4 per cent and 3.2 per cent, respectively. By comparison, the plain-vanilla BMO Equal Weight Banks Index ETF (ZEB) returned 7.5 per cent, the BMO Canadian Dividend ETF (ZDV) returned 5.9 per cent, and the BMO Equal Weight Utilities Index ETF (ZUT) gained 11 per cent.

What’s more, all three covered-call ETFs trailed the S&P/TSX Composite Index’s total return of 6.5 per cent over the same period. A difference of a few percentage points in return may not seem like much in the short run. But over the long run, it can really add up.

So does this mean investors should avoid covered-call ETFs entirely? Not necessarily. In markets that are treading water or falling, covered-call ETFs can do well relative to other funds thanks to the steady premium income coming in. But since markets rise over time, there will be more periods when covered-call ETFs underperform.

Bottom line: If you’re comfortable giving up some capital gains over the long term, and you need to supplement your cash flow now, there’s no reason you can’t invest a portion of your portfolio in high-yielding covered-call ETFs. But you need to understand that those higher yields come with a cost.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.