The real costs of covered-call strategies

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Canadian investors have developed a nose for yield. Option-based ETFs’ assets grew by $4.4 billion last year to $17 billion, according to National Bank. High yields and modest protection grabbed attention during a time when market turmoil made upside impairment irrelevant.

Some expectations for covered-call ETFs may be too good to be true, though. While the products can be great tools, they require scrutiny to use effectively.

Covered calls, which account for 90% of option-based ETF assets, involve selling a call option on a stock you own. When you sell a call option, you give the buyer the right (but not the obligation) to buy your stock at the strike price by an expiration date. In return, you receive an option premium.

You can earn extra income, but if the stock rises above the strike price of the option you sold, the option buyer will likely exercise their right to buy the stock from you and you’ll miss out on gains above that price. If the stock price remains the same or declines, you keep the stock and the option premium.

Table 1 below, compares 10 covered-call ETFs (in bold) to passive products in the same category.

Table 1: Covered-call ETF comparison

Click image for full-size chart

There are four key takeaways.

1. Covered-call strategies tend to offer higher yields

Across all nine categories, the yields on call-writing ETFs were higher than those of their chosen comparisons, in some cases significantly so. The spread between covered-call and passive strategies expanded in the more volatile technology and health-care sectors, which command higher option premiums.

Investors should check if sponsors are unduly increasing yield by returning capital to unitholders, thus reducing the cost base. If an ETF is not consistently earning its target yield of dividends plus capital gains (option-premium capture is treated as a capital gain), principal may be eroded. Annual distributions for the BMO Covered Call Canadian Banks ETF over the past decade have been about 50% dividends and 50% return of capital, a good balance for a 50% overwritten portfolio.

2. Covered-call strategies sacrifice upside in sustained up markets

All covered-call ETFs except the BMO Europe High Dividend Covered Call ETF had lower “best three months” performance than their passive counterparts.

3. Downside protection isn’t consistent

The “worst three months” column shows the utilities, health-care and energy products provided some downside protection. But the covered-call technology and broad market funds performed worse than the passive funds.

4. Covered-call strategies cost more

All 10 covered-call ETFs had higher MERs than their passive cousins. In part, this is due to active trading expenses for period-to-period rollovers. Sometimes the ETF’s structure contributes. The Hamilton Enhanced U.S. Covered Call ETF, for example, buys units of other covered-call ETFs and adds up to 25% leverage, so its base management expense ratio is 2.09%.

Using covered-call ETFs is not a set-and-forget strategy. Because it works best in rangebound markets, financial advisors must be prepared to conduct cost-benefit analyses when market conditions change.

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.