A popular type of ETF these days uses covered calls to increase the income that the ETF pays out.
These ETFs often hold the exact same holdings as their non covered call counterparts. The difference being the covered call variants are attempting to boost their distributions by collecting premiums by selling call options. Lets go over some of these that exist amongst Canadian ETFs and weigh some possible pros and cons.
So what is a call option, and what is a covered call ETF?
For those that don’t know, call options are a contract that gives the buyer of the option the right to purchase stock from the seller of the option at a set price for a limited amount of time.
The buyer pays the seller a premium for the right. As a generic example, you may pay a $100 premium right now to have the right to purchase 100 shares of stock ABC by March 19th 2021 at a particular price, called the strike price.
Or, as the seller of a call option, you will receive $100 now, but have to be willing to sell 100 shares of ABC stock to the option buyer on or before March 19th 2021 at the strike price.
Investors have the option to sell call options on stocks they own, known as a covered call option, or on stocks they do not own, known as a naked call option.
Lets look at an example of a covered call
If I own 100 shares of Royal Bank stock (currently $109.77), I can sell 1 call option to sell my shares at $112, that expires in 55 days and I’d receive $114 as a premium ($1.13 premium per share).
So to sum this up
- I own 100 shares of Royal Bank, currently trading at $109.77
- The call options expiry is in 55 days
- The call options strike price is $112
- I’m getting paid $114 to sell this option
- Once sold, I have the obligation to sell the shares to the option buyer on or before the expiration date (55 days) at the strike price ($112)
If RY stock is under $112 in 55 days, the option expires and I get to keep my 100 shares and I still have the $113 premium.
This is because although the person who bought my call option has the ability to purchase 100 shares from me for $112, they’re not going to do so if they can buy it cheaper on the open market.
If the stock is over $112, the buyer of the option has the right, but not the obligation, to purchase my RY shares.
The call option buyer would likely exercise the option, in which case I would be paid $112 for my RY shares and I would keep my $113 premium.
Investors often use covered calls to increase their income from their portfolio
Royal Bank pays a 3.94% yield, $4.32 per share annually, which means that my 100 shares in the example above would pay me $432 in dividends this year.
As you can see, by writing (selling) one call option, I increased the income from my shares by $113, or 26%. And the option contract only lasted 55 days.
If the contract expired because RY stock was less than $112 at the end of the contract, I could sell another covered call option for more income.
You can see how selling covered call options is a powerful tool for increasing investment income. This is why covered call option ETFs are so appealing to investors.
You may have noticed the problem with covered calls, and ultimately covered call ETFs though
If the underlying stock goes up, a covered call limits your upside.
In my example, if Royal Bank stock is over $112, I may be forced to sell it at the price no matter how high the share price is. It doesn’t matter if Royal stock increases to $120 because I have to sell my shares for $112.
In a rising market this hurts the returns of covered call ETF investors.
Canada’s Largest Covered Call ETF ZWB.
Canada’s best known covered call ETF is the BMO Covered Call Canadian Banks ETF (TSE:ZWB). It has $1.9 billion in assets under management.
It is similar to the BMO Equal Weight Banks Index ETF (TSE:ZEB). In fact, ZEB is actually held in ZWB (27.48% of assets).
If you are just looking at the yields of the two ETFs, you can see the effect of the covered call strategy. ZWB yields 5.64% versus ZEB’s yield of 4.02%.
Despite that higher yield though, ZWB has consistently underperformed ZEB.
Over the last ten years, ZWB has produced a total return of 7.81% annually, 1.52% a year less than ZEB (9.33%).
That might not sound like much of a difference, but a $10,000 investment in ZWB ten years ago is worth $20,948.08 today while a $10,000 investment in ZEB ten years ago is worth $25,190.97.
Even though ZWB had a substantially higher yield the whole time, because the covered call strategy limits upside in a bull market, investors ended up with much less money than they would have by investing in ZEB.
The biggest reason for this underperformance is the bull market of the last decade.
The performance over the last year shows that even without a bull market covered calls can underperform.
Banks got hit hard in the worst of the COVID-19 crisis, and recovered more slowly than lot of companies. The price of ZEB is pretty much exactly what it was one year ago.
You’d think that would be a perfect environment for covered calls to outperform, but ZWB underperformed ZEB over this period as well, returning 0.80% versus ZEB’s 2.87%.
The underperformance of the covered call banks ETF isn’t specific to ZWB
There is another ETF, CI First Asset CanBanc Income Class ETF (TSE:CIC), that holds Canadian banks and increases its income by selling covered calls. CIC has also underperformed ZEB over the last ten years, providing a total return of just 7.61% annually.
Investors might be tempted by the ETF’s 9.1% yield, but it’s important to look back to see that the high yield comes at the expense of capital gains and investors can end up with a lower return.
A Covered Call High Yield ETF ZWC
Another popular covered call ETF, with $823 million of assets, is the BMO Canadian High Dividend Covered Call ETF (TSE:ZWC).
The ETF owns high yielding Canadian stocks, weighting them in the portfolio according to yield and diversifying across sectors.
ZWC has a high yield, currently 7.87%. Despite that yield, it has performed poorly since its inception in early 2017.
Because it is a fairly new ETF, we don’t have a ten year track record for comparisons, but the three year track record shows the ETF’s pitfalls.
Over the last three years, ZWC has had a total return of just 0.23% annually.
There isn’t a perfect ETF to compare ZWC to, but there are two high dividend yield ETFs that have similar holdings to ZWC. Lets take a look at performance.
The FTSE Canadian High Dividend Yield Index ETF from Vanguard (TSE:VDY) has 9 of its top 10 holdings in common with ZWC’s top 10 holdings, making them similar.
Over the last three years, VDY has returned 3.37% annually. This is 3% more than ZWC on an annualized basis.
The iShares S&P/TSX Composite High Dividend Index ETF (TSE:XEI) isn’t as similar to ZWC, just 6 of its 10 overlap with ZWC’s top 10.
XEI has also outperformed ZWC. Investors of XEI have had a total return of 2.57% per year over the last three years.
Investors looking at high dividend ETFs will probably be concerned with the yields of the ETFs, and that would probably make them think seriously about choosing the covered call ETF.
VDY has a trailing yield of 4.59% and XEI’s trailing yield is 4.75%.
Those are attractive in their own right, but investors might get tempted by ZWC’s much higher 7.87% yield. Once again it is more important to look at the total return.
Higher Fees with covered call ETFs
There are more examples of covered call ETFs underperforming their equivalents that don’t write covered calls; this article could go on forever covering them all (pun intended).
But let’s instead look at one more thing covered call ETFs have going against them, and that is the fees.
Covered call ETFs are more difficult to manage than a regular ETF. All BMO has to do to manage its Equal Weight Banks Index ETF is hold the stock of the banks and rebalance its holdings regularly.
To manage the Covered Calls Canadian Banks ETF, it has to hold the stock of the banks, rebalance regularly, and sell the covered calls.
Because there is more work involved, BMO charges a higher fee. The management expense ratio (MER) of ZEB is 0.61%, and the MER of ZWB is 0.71%.
The higher fees of covered call ETFs generally holds true for all of them.
The New Kid on the block
With all of that said, allow me to introduce you to Canada’s newest covered call ETF. This one is also from BMO.
The BMO Covered Call Technology ETF (TSE:ZWT) was introduced on January 20th, and since then has gained $9.46 million in assets under management.
The purpose of the ETF is to give investors exposure to North American technology companies, and to provide extra income by writing covered calls.
Its Top 10 holdings include the tech giants Alphabet, Microsoft, Amazon, Facebook, and Apple, as well as Visa, Mastercard, Paypal, Nvidia, and Adobe.
Over the last 5 and 10 years, technology has the best performing sector in the S&P 500.
The Invesco QQQ ETF (NASDAQ: QQQ) tracks the NASDAQ-100 Index, which has similar holdings to ZWT, and has returned over 20% annually over the last ten years.
Investors who primarily focus on dividend yields have missed out on a lot of that performance because technology companies tend to pay such low dividends. The yield of QQQ is just 0.52%.
A new ETF that provides a way to get income from technology investments is probably appealing to many of those investors.
ZWT is so new that it has only declared one distribution, but based on that one, we can estimate that ZWT is going to yield approximately 5% per year, with monthly payouts.
The covered call strategy might also appeal to investors who fear that technology stocks are expensive right now. If tech stocks go down, the fall is cushioned a little bit by the extra income.
Potential investors should be warned though, the main quality that has made technology such a good investment has been the sector’s growth.
By investing in the BMO Covered Call Technology ETF, they could miss out on a lot of those future gains.