Covered-call ETFs becoming popular for yield-hungry investors

ETFs that write call options against the stocks they hold have become some of the highest-yielding products in the Canadian market.

A CIBC World Markets Inc. report released in August called covered-call ETFs “the go-to product for Canadian investors who want high yield — a feature of paramount importance for retirees who are often living off distributions.”

The report identified 65 ETFs with covered-call mandates holding assets totalling about $12 billion. With distribution yields mostly in the 5%–10% range, covered-call ETFs offer the highest payouts in the Canadian ETF universe, CIBC concluded. Topping its list for the 12 months ended in July was the CI Gold+ Giants Covered Call ETF, which yielded 11.6%.

The dominant player in covered calls is Toronto-based BMO Asset Management Inc., with a dozen listings and about $8 billion under management. Other leading providers are Toronto-based CI Investments Inc., with $1.8 billion in nine ETFs, and Oakville, Ont.-based Harvest Portfolios Group Inc., with $1.3 billion in an industry-leading 14 ETFs.

Weighing in with eight covered-call ETFs each are Horizons ETFs Management (Canada) Inc., Brompton Funds Ltd. and Evolve Funds Group Inc., all based in Toronto.

Investors and their advisors should ask themselves three primary questions when considering the suitability of covered-call ETFs, said Paul MacDonald, Harvest’s chief investment officer. First, do they want to be invested in the underlying sector or strategy? Secondly, do they need regular high income? And thirdly, are they willing to forgo some potential capital appreciation?

If the stock rises beyond the strike price of the option, the option will be exercised. If the capital appreciation exceeds the amount of premium received by the option writer, the option buyer will reap the benefits. But in the event of a significant decline in stock prices, the premium income will partly offset capital losses for the option writer.

ETF companies take different approaches in striking a balance between generating call-writing income while still maintaining exposure to the underlying stocks.

The BMO ETFs, for instance, will generally write covered calls on half of the stock holdings. At the 50% level, investors can still get capital growth out of the portfolios, said Mark Raes, head of product with BMO Global Asset Management Canada. “The last thing you want to do is get a heavy income stream and then look five or 10 years down the line and realize you’ve eroded your capital,” he said.

To that end, the Harvest ETFs are tilted more toward capital growth, since they limit covered-call writing to 33% of each stock holding. “We want to be in areas that have long-term secular growth, but we also want to generate high cash flow,” MacDonald said. “And so we don’t want to forgo all of that upside on the stocks.”

The CI ETFs apply an even lighter touch to covered-call writing. Their maximum is 25% of each stock. “We’re able to capture around 75% of the upside in rising markets, while still providing some income and degree of downside protection in declining markets through that option premium generated,” said Nirujan Kanagasingam, CI’s vice-president of ETF strategy. Unlike most covered-call ETFs, which make monthly distributions, CI does so quarterly.

The Brompton ETFs take a much more active approach to covered-call writing. Though firms with specific call-writing limits say they have the flexibility to make adjustments depending on market conditions, Brompton has no minimums or maximums.

“Our portfolio managers can choose the portfolio coverage level and strike price, the goal being to positively impact total returns,” said Chris Cullen, a Brompton senior vice-president and head of ETFs.

For example, unlike firms that tend to write calls that are at-the-money or close to it, Brompton managers may opt for out-of-the-money strike prices. “The stock price has more room to appreciate before there’s a risk that the option will be exercised,” Cullen said.

For covered-call ETFs as a whole, the biggest determinant of total returns will be the underlying stocks. The two main types of mandates — broad market and sector-specific — are both represented in the BMO lineup.

Six of BMO’s ETFs are also positioned as geographic high-dividend strategies, ranging from Canadian and U.S. to European and global markets. For these income-oriented ETFs, covered calls are “an enhanced dividend strategy first and foremost,” said BMO’s Raes. “When dividend funds really can be core pieces of your portfolio, so can covered calls.”

Over at CI, all of the covered-call ETFs are sector mandates (specializing in technology, health care and energy, among other areas) intended to complement more diversified core holdings.

“These ETFs allow investors to express their views and get that target exposure to specific sectors of the market,” Kanagasingam said. “And also it’s a great way for investors to access and receive income in certain sectors that don’t traditionally offer high income.”

With the exception of the Harvest Brand Leaders Plus Income ETF, Harvest’s covered-call ETFs also are sector-specific. These types of mandates, such as technology and health care, tend to generate higher option premiums than more stable sectors such as consumer staples or utilities, MacDonald said. That higher volatility “has allowed us to pay out higher monthly cash flows.”

Another benefit of covered calls is tax efficiency, since the premium income generated is deemed to be capital gains. To take full advantage of favourable taxation, covered-call ETFs would need to be held in non-registered accounts. However, because of their high distribution yields, these ETFs can still be appropriate for RRSPs and other registered accounts.

“Capital gains can be very effective for somebody who needs cash flow in their registered account,” MacDonald said.

Finally, ETFs that generate option premium income are a convenient alternative — at management expense ratios that are generally in the range of 70 to 100 basis points — to direct ownership of stocks on which calls can be written.

“Covered-call ETFs allow investors to get efficient exposure to covered-call strategies without the complexity and time-consuming nature of writing calls yourself,” Kanagasingam said.