Generating tax-free income in TFSAs with covered-call ETFs gains popularity

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Tax-free, high-yield income is likely to grab the attention of many retirees and their advisors, and that’s exactly what an increasingly popular strategy entails, utilizing the tax-free savings account (TFSA) and covered-call exchange-traded funds (ETFs).

Given that retirees now have potentially $88,000 in TFSA contribution room, many could devote a sizable sum of capital to these increasingly popular ETFs that generate monthly distributions, with annual yields that can exceed 10 per cent.

The strategy combining these ETFs with a TFSA has gained popularity among do-it-yourself investors. Among them is former Montreal resident Adriano Starinieri, creator of the YouTube channel Passive Income Investing, who at age 37, says he’s “financially independent” as opposed to “retired” and now living in Panama.

“The bread and butter of my investment strategy for income is covered-call ETFs,” he says, adding that many of those funds are held in his TFSA, providing tax-free income.

He likely isn’t alone. His YouTube channel has more than 60,000 subscribers, many of whom are retirees interested in the TFSA/covered-call strategy, Mr. Starinieri notes.

While potentially a complementary income strategy for retired and retiring clients, it’s not without risks and may not be as effective as other approaches to generate income across various market conditions, says Andrew Feader, wealth management advisor at IceCap Asset Management Ltd. in Toronto.

“It could be the right solution for the right client,” he says.

He notes that some married clients now have TFSAS of about $300,000 combined. In theory, even a relatively conservative covered-call ETF with a 7 per cent annual yield – generated by dividends and call option premiums – could provide them with $21,000 in tax-free income annually.

While likely not enough to cover all their costs, the strategy could provide significant tax-free income, layered onto taxable sources, ideal to pay for emergencies, renovations and travel.

‘Slow rising market going forward’

Still, Mr. Feader admits he has yet to use the strategy for clients – although he’s now considering its merits.

“The reason is we think we could see a prolonged flat or slow rising market,” he says, which is when covered-call strategies often work best as the stocks on which the options are written are less likely to be called away.

In contrast, over much of the past decade – a historic bull market for stocks – covered-call ETFs still provided a good yield and return, but they were more likely to see call options hit their strike price resulting in the ETF selling some of its top-performing stocks. In turn, these ETFs would underperform ETFs with the same holdings and no options strategy.

For this reason, among others, Dave Holt, private wealth counsellor at Mercer Global Investments Canada Ltd. in Winnipeg, would be unlikely to use covered-call ETFs for clients either inside their TFSA or elsewhere.

“The best apples-to-apples comparison,” he says, is BMO Covered Call Canadian Banks ETF ZWB-T and BMO Equal Weight Banks Index ETF ZEB-T, which have track records exceeding 10 years.

Both have the same underlying stocks and allocations, but BMO Equal Weight Banks Index ETF, which doesn’t use covered calls – has a 10-year total return of about 10 per cent annualized versus BMO Covered Call Canadian Banks ETF, which has an annual return of about 8 per cent.

While covered-call ETFs’ monthly distributions are attractive for many retirees, Mr. Holt notes a total return approach to a retiree’s portfolio – using capital gains and dividends to generate income – could provide superior performance long-term while preserving more capital.

“Because there’s no free lunch, in the long run, a covered-call strategy at best breaks even with a plain-vanilla ETF holding the same stocks,” he says.

Although missing out on some upside of a fast-rising market is a key risk, an arguably bigger concern is downside risk, Mr. Holt says.

“You bear almost 100 per cent of the loss in a declining market,” he adds.

Managing client expectations

That said, BMO Covered Call Canadian Banks ETF – because it was still collecting premiums on call options written on a portion of the portfolio – performed slightly better than its non-covered call counterpart in down markets conditions over the past decade.

Yet, the real risk lies with expectations of clients, who may have a myopic focus on the ETFs’ high income while losing sight that they are exposed to equity market risk.

Mr. Holt points to the pandemic meltdown as one example in which retired clients’ nerves might have become frayed. From March 25, 2019 to March 23, 2020, BMO Covered Call Canadian Banks ETF fell almost 34 per cent in value, he adds.

“Of course, this is the depths of the COVID-19 decline, but if investors did not expect this and experienced such discomfort that it caused them to sell, this would be a very bad outcome,” he says.

Compounding the pain, the realized loss in a TFSA could not be used to offset taxable, realized gains on non-registered assets, he adds.

Helping to diversify income streams

Still, the strategy can make sense for some retired clients provided they understand the risks well, says Darren Coleman, senior portfolio manager, private client group with Coleman Wealth at Raymond James Ltd. in Toronto.

“If part of a broader portfolio, the strategy can help diversify income streams,” he says, adding his practice has long used covered-call ETFs, including inside TFSAs.

Given the sheer choice among funds today – from lower-risk bank ETFs to higher-risk/higher-yielding technology funds – advisors “can’t just grab any product off the shelf,” he cautions.

In Canada alone, investors have dozens of covered-call ETFs to choose from, including recently issued single-stock ETFs involving leverage on a portion of the underlying securities.

A key point Mr. Coleman emphasizes is that the more volatile, or risky, the underlying assets are, the more yield the ETF generates due to higher income from call premiums.

“For some clients, not all, this is an interesting idea because it turns volatility into an income driver,” he says.

Indeed, this trait is attractive to Mr. Starinieri and other proponents.

“The more aggressive the covered-call ETF strategy, the more income you’re going to get, but it’s important to understand this also means you’re giving up more stock price appreciation potential,” he adds.

The challenge for advisors, though, is ensuring clients do not focus only on high yields while overlooking underlying equity risk.

“The biggest risk is misunderstanding the product,” Mr. Holt says.

Not only might clients want to sell the ETF in a down market, but “maybe, they consider firing their advisor too,” he adds.

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