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Oil prices are trading at their highest levels in more than three years. For sure, the sector is a lot healthier than it was a couple of years ago when the price of a barrel dipped below US$40. Still, it’s understandable that many risk-averse investors don’t want to buy shares in even the higher-yielding oil companies because of volatility concerns.

One way to mitigate the risk is to use a covered call ETF as a proxy for the industry. The call options provide extra cash flow and help to provide a downside buffer. That doesn’t mean such exchange-traded funds are immune from market forces – they’re not. But if you are willing to take on a little more risk to gain some exposure to the energy sector plus a high yield, here’s a way to do it.

First Asset Energy Giants Covered Call ETF

Symbols: NXF-TSX (C$ hedged); NXF-B-TSX (unhedged)

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Current price: NXF: $8.61; NXF-B: $9.47

Annual payout (2017): NXF: 52.4 cents, NXF-B: 53.06 cents

Current yield: NXF: 6.1 per cent; NXF-B: 5.6 per cent

Management fee: 0.65 per cent

Risk: Higher

The security: This ETF invests in the 15 largest non-Canadian energy companies. These may be integrated firms or exploration-and-production companies. The managers generate income through dividends and writing (that is, selling) at-the-money or near-the-money call options on 25 per cent of the shares of each company in the portfolio.

Major holdings include Occidental Petroleum Corp., ConocoPhillips Co., CNOOC Ltd. (China’s largest producer of offshore oil and natural gas) and EOG Resources Inc., the successor to Enron, which is a major U.S. exploration company.

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Why I like it: The energy industry is in better shape than it was two years ago. Oil companies have tightened their belts, reduced expenses and cut capital spending. They are leaner and more competitive now. The Bloomberg World Energy Index was up 5.1 per cent for the year as of the time of writing. This ETF offers a way to get exposure to the energy sector while generating good cash flow at the same time.

Key metrics: The combined fund has about $44-million in assets under management. It was launched in February, 2015, so we have a little over three years of history to work with. There are about 4.9 million units outstanding, roughly equally divided between the hedged and the unhedged versions.

Performance: This fund was launched as oil prices were on the way down, so both versions got off to slow start. As of June 29, the unhedged fund was showing a three-year average annual compounded rate of return of 6.7 per cent mainly as a result of currency gains. The hedged version was up 3.6 per cent annually in that period.

More recent results have been much better, however. The one-year gain for the unhedged fund was 29.3 per cent while the hedged version was 26.2 per cent.

Risks: The price of oil is the key determinant and the market are highly volatile, as recent price movements show. An increase in supply could send prices lower, although the anticipation of that happening may have already taken much of the market sting out of the actual event if it comes. Two wild cards that could push prices up again are the meltdown of Venezuelan production and the impact of renewed U.S. sanctions on Iran. The latter was exporting two million barrels a day prior to U.S. President Donald Trump pulling the plug on the nuclear agreement and calling for tough new sanctions.

Distribution policy: Distributions are paid quarterly and vary. The latest payout was in June, at 15.7 cents a unit for the unhedged fund and 15.29 cents for the hedged version.

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Tax implications: The distributions are treated mainly as capital gains or return of capital, giving the fund a tax advantage if the units are held in an unregistered plan.

Who it’s for: This ETF is best suited for investors who are prepared to accept a higher degree of volatility in exchange for more exposure to the energy sector and good cash flow.

How to buy: Both versions trade on the TSX. Volume is low on most days, but there are occasional spikes that suggest large blocs are changing hands.

Summing up: This ETF is a unique way to get exposure to the international energy sector. The hedged version protects you against currency fluctuations, removing one element of uncertainty. However, the unhedged version has tended to be the stronger performer so far. Either would be a decent choice depending on your personal priorities, your view of the future of the loonie and your risk tolerance.

Guidance: Buy. Remember, this security is only suitable for more aggressive investors. Consult your financial adviser.

Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to buildingwealth.ca.

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