Over the last few years, a passive income craze has taken the markets by storm. It seems like new funds are appearing every month, and it’s hard to distinguish what is quality and what should be avoided.
It is no surprise that during the live Q&A of our Market Mindset episode last Tuesday (if you missed the episode, click here to watch the replay) that HMAX, the Hamilton Canadian Financials Yield Maximizer ETF, was brought up.
The fund has a yield of nearly 14.5%, and many do not understand how this fund can generate almost 14.5% while containing Canada’s big banks, some insurers, and Brookfield.
I felt it would be good for me to review this ETF from a completely unbiased standpoint and provide my thoughts on the passive income craze in general and the added exposure these types of funds have gotten from the passive income community.
Much of the information on various Youtube channels and websites is biased toward generating the maximum amount of passive income without regard for long-term returns or volatility.
Members can then utilize this information to make a more educated decision on whether or not they want to own this fund.
If you enjoy these sorts of reviews, please let us know. We’d be happy to provide more of them, as we spend a lot of time sifting through and researching ETFs.
A review of Hamilton’s new financial ETF, HMAX
First, I think we must dig into what exactly Hamilton is. Compared to other fund managers like iShares, Vanguard, or BMO, it’s relatively small. Hamilton was founded in 2009, making the timeline of its existence relatively small compared to the others as well.
I would view Hamilton as more of a niche ETF provider that allows investors to gain exposure to particular segments of the market or investment strategies that are not easy to replicate. For example, they have a fund that tracks the Australian Banks under the ticker HBA.
The passive income craze
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I have attached a 20-year graph from Google Trends for the phrase “passive income” above (if you cannot see it, make sure your mailing client accepts images.)
The chart shows an increase in popularity starting in late 2017 but exploding through the COVID-19 pandemic.
It makes complete sense. The global lockdowns were happening, and the fear of losing one’s job was very real at that time. The thoughts of having an income stream that couldn’t be touched by anyone or impacted by your employer caught on in a big, big way.
As a result, fund managers started producing and pushing passive income funds at a rapid pace. These funds existed pre-pandemic, but make no mistake; they have skyrocketed in popularity since the March crash of 2020 due to the pandemic, with Hamilton leading the charge here in Canada.
That is not to say fund managers in the United States aren’t taking advantage of this phenomenon either. Funds like JEPI, JEPQ, and RYLD have all, for the most part, existed only in a pandemic and post-pandemic environment.
What does this mean for investors?
When we think about these ETFs and fund managers, they are all competing for one thing and one thing only: assets under management.
If the craze is passive income, they will produce passive income funds that aim to deliver investors what they want.
To capture more assets from the public, they also need to make their fund the best. There is competition everywhere in the ETF space, with only a finite amount of investor money to go around.
As a result, we are now experiencing more and more funds being pushed to the market where a simple high-yield target strategy isn’t working.
A simple fund targeting high-yielding equities, at least to the passive income crowd, isn’t good enough. Many of these funds are now in a situation where they are forced to do what I like to call “financial engineering” when it comes to their ETFs.
Covered calls, leverage, even the combination of both. Selling options contracts that generate higher cash premiums now but will no doubt impact the fund’s long-term performance. All in the name of passive income.
I find there is an increasing number of investors that are chasing high income now, and they are either willing to ignore specific strategies set out by high-income funds that will impact long-term performance, or they are simply unaware.
These funds may be perfect for some people who are in a situation where the increased income benefits them more now. However, if your time horizon is 30, 20, 15, or maybe even 10 years, you may be kicking yourself later on for collecting this financially engineered income stream when you don’t need it.
The basic premise of Hamilton Canadian Financials Yield Maximizer ETF (HMAX)
In reality, HMAX is a very simple fund, so the explanation of it will be relatively brief. Knowing the underlying strategy and what it means is much more important than dissecting the fund in depth.
In short, HMAX holds a portfolio of Canadian financial stocks, including all Big 6 banks, Brookfield Corp, Manulife, Sunlife, and Intact Financial.
The backbone of this fund is that it will sell “at the money call options” to generate premiums to provide significantly more income to fund holders than just the dividends from the companies alone.
The fund holds blue chip finance stocks and then sells options contracts on those stocks to give more back to shareholders.
Now we need to get into the basics of covered calls to figure out how HMAX is able to generate more money than other covered call funds, and finally, why I think it’s a bad strategy over the long term.
The basics of covered calls
For me to explain why HMAX’s strategy is different, it’s important that you first know the basic structure of a covered call. After this, you’ll understand why these funds can provide the distributions they can.
And ultimately, it will give some truth to a famous phrase: there’s no free lunch in finance.
A call option is a contract between two investors that gives the buyer of the contract the right, but not the obligation, to buy 100 shares of the underlying asset at a specific price.
Every option contract has an underlying asset
It could be a stock. It could be gold. It could be an ETF. If I want to buy an option on the Royal Bank of Canada, RBC’s stock is the underlying asset to which the options contract is based on.
From there, every option contract must have an expiry date
You can buy options that expire in one day, or you can buy options that expire in one year. Typically, US listed stock options expire on the third Friday of every month.
An option contract must also have what we call a strike price
The strike price is the price at which the shares will be sold to the buyer of the call option if they wish to execute it.
So, if you are buying a RY Jun 16 2023 $145.00 call option, you are effectively entering a contract that says up until June 16th, 2023, you want to have the right to buy 100 shares of Royal Bank off the option seller at any time, at a price point of $145 per share.
You will pay a premium to the options seller for this right. This premium is precisely how these funds can generate high yields.
The funds are not the buyers of call options; they are the sellers of call options. They don’t pay the premium; they collect the premium.
As the seller of this hypothetical RY option contract, you’ve entered a contract that says you will sell 100 shares of Royal Bank of Canada for $145 if asked to, up until June 16th, 2023.
Depending on the overall volatility of the stock and what strike price you’ve chosen (this comes into play later with HMAX), the premium you pay as the buyer, or collect as the seller, can vary.
Generally, the closer the strike price is to the current stock price, the higher the premium.
This is because this option is much more likely to be executed than one further from the current price.
Lets go over an example to make this make sense
At this point in time, Royal Bank is trading at around $134.50
If I were to come to you and say:
A: “What would you want me to pay you to guarantee me the sale of 100 shares of Royal Bank at $135 over the next month if I wanted to.”
Or
B: “What would you want me to pay you to guarantee me the sale of 100 shares of Royal Bank at $180 over the next month if I wanted to.”
You’d likely want a lot more money for the $135 contract in case A. Why?
There is a much higher possibility that Royal Bank goes above the $135 price point, and you may be forced to sell me 100 shares at less than market value.
Remember, a call option gives the buyer the right to buy shares at a specific price. In case A, the strike price would be $135. If Royal Bank went to $150 over the next month, you’d have to sell me 100 shares of a $150 stock for $135 each.
In the $180 situation in case B, you’d likely be comfortable offering me that deal for less money, as it’s highly unlikely that Royal Bank will go to $180 in the next month.
For the $180 option, let’s assume the same increase of Royal Bank’s stock to $150. As the buyer of the option at $180, I won’t exercise my call option and buy Royal Bank from you at $180 when I can buy it at $150 on the open market.
If I do not exercise the call option, you collect the premium and still hold your 100 shares of Royal Bank.
The funds we are talking about sell options, collect the premiums, and rinse and repeat. That is precisely how these funds generate additional income for their holders.
The unique strategy of HMAX and why I’m not a huge fan
As we covered, the closer the stock price is to the strike price of an option, the more the seller of that option should demand in terms of a premium.
HMAX looks to intentionally take advantage of this by selling options contracts close to the underlying asset’s current share price. They call this “at the money” or “in the money” options.
From the abovementioned situation, HMAX would be interested in case A and not so much in case B. In case A, the fund collects a much higher premium, knowing that the contract is much more likely to be exercised.
However, this strategy has a glaring issue when looked at from a long-term perspective, and it’s easily summed up in a single chart.
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As you can see, Canadian banks have had a stellar performance over the last decade. Considering this, if HMAX is selling options contracts that are tight to the stock’s price, there is a high likelihood that, over the long term, HMAX will be forced to sell its shares at a discount to market value.
As a result, although larger amounts of income are captured, we will not be participating in all the upside the shares provide.
Hypothetically, the larger the bull run in Canadian financials, the more HMAX would suffer.
Even if the whole concept of covered calls still confuses you after reading this, just know that the more amplified the bull market, the worse covered call traders and covered call funds do.
Markets with lower volatility are not good for covered call funds
In addition to the fact that a fund like HMAX would not perform well in a financial bull market, it would also not perform as well during times of low volatility.
The higher the volatility in the markets, the richer options premiums are. This is precisely why we are seeing covered call funds like JEPI and JEPQ reducing their distributions just 2-3 years into their existence.
Volatility has reduced since the pandemic, and many of these funds are not generating the income they once were.
When HMAX could hypothetically perform well
Interestingly enough, one could argue that the best opportunity HMAX has for performing well is right now, when banks are expected to trade downwards or flat through a recessionary period.
Sellers of covered calls want stock prices to stay flat or go down. If it makes more sense for the buyer of a call option to buy the stocks on the open market versus the price they’d get with the call option, they will do so.
As a result, the seller of the options contract would collect the premium, and the contract would expire worthless. This means the seller would keep the shares of the underlying asset and the premium from selling the call option.
Theoretically, if you’re bearish on Canadian banks and Canadian financials, you would likely find interest in a fund like HMAX over the short to mid-term.
A flat market for its holdings would allow this company to collect generous premiums on tight options contracts while not having to sell the underlying shares.
Overall, this is a fund that could be looked at during short-term weakness but is likely one that underperforms total long-term returns
Nothing is ever guaranteed when it comes to the markets. We can never know when and where the bears and bulls will occur.
But the covered call strategy, particularly one that sells options contracts close to the money (close to the stock’s current price), will perform much better during flat markets to moderate bear markets.
Over the long term, it is likely fair to say that the markets will generally witness bullish activity much more than bearish. As a result, there is a high likelihood that a fund like HMAX consistently has to sell itself short and liquidate holdings for less than they are worth.
This is why you will often see these covered call funds provide nice income streams but lag the markets over the long term.
I find the strategy of selling at the money call options on Canadian banks even more puzzling, as these companies have proven over multiple decades to provide strong revenue and earnings growth.
Canadian banks are certainly a sector I may be willing to bet against during particular points of the economic cycle, but not one I’d bet against long term.
HMAX is a fund that is highly dependent on investor strategy
In our opinion, HMAX is a fund that should be utilized by those who want exposure to Canada’s banks and financial institutions, but don’t want to reap the complete benefits of holding them over the long term.
Instead, you’d be more interested in the high levels of income the funds generate, at the expense of future upside, upside that is capped even further with a fund like HMAX over other covered call funds because it sells its contracts at the money, or even in the money.
For those with a long time horizon, we are not sure we see any value in HMAX. Income always comes at a cost, and unless something material happens to Canada’s financial institutions, there is a very high likelihood that holding direct exposure to Canadian banks will outperform HMAX.
All in all, it depends on what you want to get out of your investments. We simply aim to shed some more light on these funds so you can make more educated decisions yourself.
As always, any questions, feel free to utilize the Q&A.
