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BMO Global Asset Management was the first out of the gate in launching covered-call ETFs in Canada in 2011 with BMO Covered Call Canadian Banks ETF (ZWB-T).

Fred Lum/the Globe and Mail

Exchange-traded funds (ETFs) that offer juicy distribution yields have proliferated amid paltry interest rates over the past decade.

Namely, Canadian-listed covered call ETFs that may also words such as enhanced-yield, enhanced-income, enhanced dividend or simply income in their names have grown to 66 offerings totalling $8-billion in assets under management.

Although earning extra cash on top of dividends by using an options strategy may be tempting, investors need to mindful of the risks in owning these equity or commodity ETFs – and that they aren’t always the best choice for everyone.

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These ETFs are suited to yield-hungry investors such as retirees who need regular income from their investment portfolios, but who can also tolerate potential market drawdowns, says Daniel Straus, vice-president of ETFs and financial products research at National Bank Financial Inc. in Toronto. “The average yield is about 7 per cent.”

BMO Covered Call Canadian Banks ETF (ZWB-T) was the first out of the gate when it launched in 2011. Now, this strategy can be found in ETFs focused on everything from dividend stocks to sectors such as health care, technology and gold mining.

These actively managed ETFs use a covered-call writing or “buy-write” strategy. This complex investing technique involves selling (or writing) a call option on a stock to a buyer at a specific “strike price,” which expires after a certain period.

The additional income comes from collecting option premiums (the price of the option), which will profit if the stock does not rise far above the strike price. Premiums are higher for volatile stocks. A covered-call strategy tends to outperform in flat or down markets, but underperform in rising markets.

Covered-call ETFs are not recommended for younger or long-term, buy-and-hold investors because the trade-off for getting the extra income is giving up potential upside for the life of the fund, Mr. Straus says. “Stocks are expected to grow over the long term, so you’re forgoing some of that growth.”

These ETFs can “almost certainly be expected to underperform a plain-vanilla, pure-stock strategy in almost all market environments over the very long term,” he says. “That’s the number one caveat we tell clients.”

For example, BMO Covered Call Canadian Banks ETF returned an annualized 5.43 per cent from inception in Feb. 2011 to May 31 versus 6.79 per cent for BMO Equal Weight Banks ETF (ZEB-T), the same fund without an option strategy. The 1.4-per-cent annualized underperformance is “what you would expect for any calendar period in generally up-trending markets,” Mr. Straus says.

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Most of BMO Covered Call Canadian Banks ETF’s total return came from distributions. Its price declined by 6.15 per cent over the nine years because it paid such a high yield, while BMO Equal Weight Banks ETF’s price rose by 32.76 per cent, says Mr. Straus. “This means that current investors in ZEB have a higher capital base for generating future distributions.”

Covered-call ETFs also charge higher fees – with the median cost in the 0.80-per-cent range – so that can erode returns over time, he adds.

The covered-call overlay also differs among ETFs. For Horizons ETFs Management (Canada) Inc.’s equity ETFs, the fund managers generally write call options on 100 per cent of the securities while BMO Global Asset Management cap the covered-call overlay at 50 per cent of its ETFs. Still, most ETFs’ exposure are between 20 and 40 per cent. A larger percentage provides a higher yield, but “limits upside participation,” Mr. Straus says.

Covered-call technology and health care ETFs may be enticing because they can offer high growth and yield, but these elements can work against each other. “By writing covered calls, you are adding a headwind to potential growth,” he says.

Mr. Straus recommends diversified plays, such as BMO Covered Call Europe High Dividend ETF (ZWE-T) or its unhedged version (ZWP-T), which is more of a lower-growth macro-economic call, or BMO Covered Call Dow Jones Industrial Average ETF (ZWA-T).

There are only eight U.S.-listed covered call ETFs. Unlike their Canadian peers, the U.S. funds typically track an index with rules to manage options due to stricter regulations regarding actively managed ETFs.

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Covered-call ETFs may also not be as popular in the U.S. because option premiums are taxed as ordinary income versus the more favourable capital-gains treatment in Canada, says Alex Bryan, director of passive strategies research for North America at Chicago-based Morningstar Inc.

However, these ETFs are appropriate for yield-seeking, risk-averse investors because the option premiums help reduce volatility in markets downturns, he says. “But these ETFs are not a substitute for bond funds. There’s still equity risk.”

Mr. Bryan also prefers diversified covered-call ETFs focused either on a broad market or dividends to reduce risk. Among Canadian ETFs, he likes BMO U.S. High Dividend Covered Call ETF (ZWH-T), which has about a 7-per-cent yield.

But the ETF’s 6.3-per-cent annualized return in the five years ended May 31 lagged the 8.3-per-cent for the plain-vanilla, U.S.-listed Vanguard High Dividend ETF (VYM-A), when its return is converted into Canadian dollars.

“It’s not a free lunch. If you look at returns over the very long term, the market does tend to go up, so you should expect to earn lower overall returns with potentially lower risk [in covered-call ETFs],” Mr. Bryan says.

Mike Philbrick, portfolio manager at ReSolve Asset Management in Toronto, also says covered-call ETFs can be useful for income-focused investors, but suggests considering ones in the gold-mining sector for diversification.

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These investors likely already own a portfolio of dividend-paying stocks or ETFs with holdings in financials, real estate investment trusts and utilities, but those areas are sensitive to interest rates, he says. But gold miners “march to a different drummer” and investors can benefit from the higher option premiums as their stocks are more volatile.

While some covered-call funds were in negative territory for the 12 months ended May 31, Horizons Enhanced Income Gold Producers ETF (HEP-T) gained 55.09 per cent and CI First Asset Gold+ Giants Covered Call ETF (CGXF-T) was up by 42.38 per cent.

Income-seeking investors are unlikely to consider gold miners because their stocks have low yields, but writing covered calls on this sector is a way to garner a bit of extra cash, and dampen the volatility too, Mr. Philbrick says.

With a gold-mining, covered-call ETF, “you have a diversified basket of stocks that’s very different from your dividend securities, but where you would be able to make up the yield. That’s a win-win,” he says.

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