Welcome back to another edition of the ETF Insights newsletter!
I have zero doubt that this month’s issue is going to be one of the more popular of the bunch, as I’ll be tackling an especially hot topic in the ETF market these days, that being covered call ETFs.
If you’ve followed me for any extended amount of time, you probably know that I am not a fan of covered call ETFs. However, that is not to say I dislike every covered call ETF. In fact, there are some rock-solid ones out there, and ones that have provided exceptional returns over the last while.
In this newsletter, I am going to dive deep into analyzing these funds so that by the end of it, if you’re looking to add some of these funds in your portfolio, you’ll know exactly which ones to avoid and which ones to buy.
Let’s get right into it, first with a simple explanation.
What is a covered call fund?
A covered call fund is an ETF that takes the difficulty of selling call options out of the investors’ hands and into the professional fund managers’ hands. The fund will sell call options, which are options contracts that give investors the choice to buy 100 shares of a specific security at a specific price, and in return for selling that option, they will collect a premium.
Let’s use a simple example. Stock “ABC” trades at $100. The investor sells a call option with a strike price of $110 to the buyer. The buyer pays the seller to have the right, but not the obligation, to buy 100 shares of stock ABC at $110 prior to the expiration of the contract.
If the stock trades at $120, the purchaser will exercise the option and realize a profit. If the stock trades at $105, it will not be worth it for them to exercise, as they’d be paying $110 for a $105 stock.
For the seller of the covered call, you want the latter situation. This is because you collect the premium for selling the option, plus you get to keep your shares. The first situation is suboptimal because you’ll need to sell shares that trade at a market value of $120 for $110.
The process of selling covered calls yourself is quite easy. However, for retail investors, the transaction fees can get high, and many investors are uncomfortable with the actual execution, so they turn to fund managers.
The steps to identifying strong covered call funds
#1 – Identify the portion of the portfolio that the fund writes call options on
This is quite possibly one of the most important aspects of a covered call fund that many investors overlook. In fact, I catch many investors simply looking at what they’d get exposure to and the yield the fund provides. However, the yield can end up being a gigantic trap when it comes to these funds.
If you’ve looked at any covered call fund, you will probably have heard commentary that it “caps your upside.” This is true, and it is the structure of a call option that ends up doing this. As you’ll remember, when you sell a covered call, there is a chance you will be selling the stock for less than market value.
The end result of a large bull run for the underlying holdings in the fund is that you may end up selling a sizable chunk of the portfolio at prices lower than market value, which ultimately causes the fund to underperform the total return of its underlying holdings.
This is why analyzing how much of the underlying portfolio the fund is selling call options on is so critical. If you have a covered call fund that is selling call options on 80% of the underlying portfolio, your yield will likely be much higher, as it is generating more premiums. However, your upside is capped significantly.
On the flip side, a fund selling call options on 30% of the underlying portfolio will have more of its holdings that are exposed to full market movements.
Some examples
The bad – Global X NASDAQ 100 Covered Call ETF (QYLD)
Let’s first look to a fund like QYLD, the Global X NASDAQ 100 Covered Call ETF. This fund has an especially high options coverage ratio, writing covered calls on virtually 100% of the holdings.
Notice in the chart above, the drastic underperformance relative to the NASDAQ 100 itself.
If you had bought the NASDAQ 100 10 years ago, you’d be sitting on $55,700. If you had bought QYLD, you’d be sitting on $20,999.
And this is with re-investing the distribution, so you haven’t even been able to benefit from the high distributions you are paid.
Owners of QYLD (despite the large 14%+ yield the fund provides) have cost themselves an extensive amount of money. An investor who instead just purchased the NASDAQ 100 would have substantially more flexibility and the ability to sell shares and draw down on that cash balance for a long time before getting back down to the return levels of QYLD.
There are not many examples of funds that have this high of an options coverage ratio that I would ever look to. The yields are high, yes, but the investor gives up a significant portion of the upside potential in the underlying holdings.
The good – Harvest Tech Achievers Growth & Income ETF (HTA.TO)
Let’s look to the other side of the coin here, a fund that utilizes a low options coverage ratio, in the Harvest Tech Achievers ETF (HTA.TO).
This fund writes options on only 33% of the holdings instead of 100%.
The end result? The fund benefits from more of the large bull run technology companies have gone through over the last while, as it isn’t forced to sell as many shares at less than market value. Look to the chart below to see how large of an impact this has had on its returns, because it is mind-blowing.
You’ll notice I used HTA.U. This is simply to avoid currency fluctuations impacting the results. If you had used the CAD version, the outperformance is even larger due to the weakness in the CAD.
So what should an investor be aiming for?
If I am looking to seriously consider a covered call ETF, any funds with options coverage ratios in excess of 50% would be scrapped from my shortlist. The only time I’d ever consider something higher than this is if the industry was slow-growing, or in a large bear market at the time.
Yes, your yield will be lower with a fund selling options on only a third of the portfolio. However, despite yield being the primary feature of these funds, fund managers know this, and they’ll do anything they can to get yields higher and draw in investors, even if it is detrimental to investors in the long run.
#2 – Analyze how the options are written
In the constant battle of fund managers trying to come up with the “next big covered call fund,” they will try anything to jack up the yield in an attempt to attract more investors.
One of the ways some managers will do this is by writing “at the money” call options on their holdings. Let me explain.
Every options contract has a “strike price.” If you have a $100 stock and you look at a call option with a strike price of $110, this means the holder of that call option will have the right, but not the obligation, to buy 100 shares at $110.
Generally, the farther a stock’s current price is from the strike price, the lower the premium the fund will get for selling that option.
For example, in the situation above, if the stock is $50 and the strike price is $110, you’ll get paid very little for selling that option as the likelihood of it being exercised is low. However, if you sold an options contract with a strike of $51, the premium would be high, as the likelihood of it being exercised is much higher.
As a result, funds that sell at the money call options, with “at the money” meaning the stock is trading near the current strike price, typically have much higher yields. However, you are at substantially higher risk of having your shares called away and sold.
I would generally look to avoid “at the money” covered call funds. The structure of them provides short-term increases in income for long-term underperformance.
An example – Hamilton Canadian Financials Yield Maximizer ETF (HMAX.TO)
For the most part, the Hamilton Canadian Financials fund contains the Big 6 Banks. It does have around 20%~ of the portfolio allocated to Canadian insurers, but for the most part, it’s the banks.
The fund sells at the money call options on these Canadian financial holdings. The yield is outstanding, 13.5%. However, with most Canadian financials yielding in the 4%~ range, the bulk of this increase in yield comes from the at the money options.
The banks and insurers have gone on quite the run over the last few years here, and if you’ll look at the chart below, you will see what an at the money strategy does to long-term returns.
I’ve compared Hamilton’s HMAX to both an equal-weighted Canadian bank ETF and a non-covered call Canadian financial ETF. You’ll notice the fund has drastically underperformed both of them since its inception back in 2023.
This is the end result of an at the money strategy when the stocks inside the portfolio are heading upwards. Premiums collected, yes, but lots of shares called away and sold.
#3 – Analyze the use of leverage
Fund managers know that covered call funds tend to underperform over the long run. After all, covered calls cap your upside.
In an attempt to fix this, many covered call funds have now introduced leverage to the fund in order to amplify the returns and offset the underperformance the covered calls bring with them.
More often than not, you’ll see these being labelled “Enhanced” funds. For example, the fund I went over above, the Harvest Tech Achievers ETF, has the Harvest Tech Achievers Enhanced Income ETF, where the fund utilizes 25% leverage on the portfolio.
The only difficulty I have with funds of this nature is yes, they tend to offset some of the lost upside, but not all of it. So in the event there is a market downturn, the fund will not only perform worse than the underlying assets it holds because of the larger downside due to the leverage, but it will also miss out on some of the run-up on the way back up because of the covered call premiums.
It’s not that these funds are bad. However, for many investors who utilize covered call ETFs, they’re doing so for the higher income and lower volatility. The leverage amplifies this, and although the higher yields are certainly attractive, there is no free lunch in finance, and you could end up in a situation where you are investing outside of your risk tolerance.
#4 – Pay attention to the distribution makeup
Because these funds aim to pay out a standard yield every single month, it is inevitable that some months they will not be able to generate the funds required to pay the distribution. In this situation, there could be a return of capital portion of the distribution.
Is return of capital always bad? Not necessarily. Option premiums in Canada are often treated as capital gain or ROC for tax purposes. But if a fund is consistently paying mostly ROC because it isn’t earning enough through options/dividends, that can signal “fake yield” (returning investor capital).
If the fund realizes capital losses on some stocks or has loss carryforwards, it can offset option premium gains for tax purposes. The cash flow is still there to pay you, but on the T3 tax slip, it might be reported as ROC (since net taxable income was offset by losses). This is a tax planning strategy many funds use to maximize after-tax income to investors.
However, there are also particular situations where funds will simply be promising too high a payout and distributing return of capital, or a portion of the capital you have invested into the fund, back to you.
How do we detect good ROC from bad ROC? Primarily through looking at the net asset value of the fund and also reading the fund managers’ quality. If you see things like:
“Our distributions are supported by option premiums and dividends… ROC reflects non-taxable portion.”
This is a good thing. Whereas something like:
“We aim to maintain our payout.”
It could be a sign you need to dig into how the fund’s return of capital is structured, and whether it is being utilized as a tax advantage, or it is deteriorating the value of your fund by distributing a portion of it out.
Overall, the large majority of these funds will not be worth your money. But, there are certainly some gems out there
The ETF space is largely a marketing battle for fund managers, and also a battle of introducing funds that are trending in the retail space. Post-pandemic, covered call ETFs have exploded in popularity due to their “passive income” nature.
For those in retirement or nearing retirement, these funds can provide an excellent source of income. But for those with a longer time horizon, if you are not extremely careful in deciding which funds you want to buy, they’ll leave you with less money in your pocket overall.
The idea of receiving income in order to buy more shares and “buy more income” is something that defies the way our investments work. When distributions are paid from covered call funds, the net asset value of the fund is reduced, and thus the share price is reduced. Reducing the value of the shares we hold now in order to buy more shares ultimately leaves us with the same amount of money we had before. And ultimately, that is what matters.
However, some funds are strong at writing call options and driving success. Largely from their low usage of covered calls on the underlying holdings and managers making strategic decisions to ultimately grow the fund’s assets.
One of the best in the country, in my opinion, is an ETF featured here and one I spoke about above, the Harvest Tech Achievers Income ETF (HTA.TO).
It has a strong history of outperformance and being relatively conservative with its options writing strategy. Sure, it doesn’t yield the 14%+ a lot of these funds do. However, yield is not everything; it is simply one piece of the pie.
