ETF Investing

Recent ETF launches employ a classic income-enhancing strategy on our three most popular sectors.
By John Gabriel | 05-02-11

The exchange-traded fund industry in Canada continues to bloom, with many new funds delving into more niche strategies. Recent examples are the covered call ETFs launched by BMO and Horizons, which forfeit some upside potential in exchange for collecting extra income in the form of option premiums. On the heels of these recent launches, we thought it would be helpful to take a closer look at this strategy to gauge suitability and determine what role (if any) they could play in your portfolio.

About the Author
John Gabriel is an ETF strategist with Morningstar, responsible for Canadian ETF research. He welcomes your comments and queries at john.gabriel@morningstar.com but cannot provide individual advice. Join the discussion and follow John on Twitter: @MstarJohnG.

The popularity of covered call strategies stems from investors' demand for yield in the current low interest rate environment. Collecting premiums from selling call options is a relatively low-risk income-enhancing strategy.

For example, let's say that you picked up some shares of iShares S&P/TSX 60 Index XIU in July of last year. You are now sitting on a gain of more than 20%. If, like our Morningstar analysts, you feel that the market is approximately fairly valued at these levels, you may not see much potential for the market to go up or down over the next couple of months. Selling the ETF now would incur a short-term capital gain. An alternative approach would be to write a call option, perhaps at a strike price 5% above the market price. As of this writing, XIU is trading at about $19.80 and May call options with a strike at $21 currently trade for about $0.10 for one contract covering 100 shares of the ETF.

Now, at expiration in one month, if XIU goes down or goes up by less than 5% (the most likely scenario), the option expires worthless, but you keep the premium and your underlying position in XIU. But if the market goes up by more than 5%, you still keep the premium, your position in XIU will get called away and for it you will get paid the strike price of $21 per share. So if the market does go up, your upside is capped at about 7% (the return from $19.80 to the strike price of $21 plus the $0.10 premium). If it falls, your downside is reduced slightly by the amount of the premium.

While it may seem like a drawback that your ETF gets called away when the market goes up, remember that your view was that the market was fairly valued and unlikely to move strongly in either direction. In short, the strike should be at a price that you would be comfortable parting with your shares. Although having your ETF shares called away will trigger the short-term capital gain, you have earned an additional 7% (annualized) by employing this strategy.

Another instance where covered call writing may be appropriate is when market volatility is high and you expect it to fall. Volatility is the underlying driver of options prices. The greater the volatility, the greater the probability that the underlying security may make a big move and end up in the money at expiration. By rolling contracts month to month and keeping exposures to 30 days or less, an investor would be able to take advantage of rising volatility in the markets. This is a similar concept to the bond investor who manages the duration of his portfolio around movements of interest rates. It swings both ways. So for instance, if we were to experience a sharp rise in implied volatility and options became relatively expensive, an investor could extend his or her exposure out to a year or more to lock in nice fat call premiums.

Of course options aren't for everyone, and each investor's situation is unique. Among things to consider would be the cost basis of the investment being secured by the call options, whether the investor is willing to trigger a taxable event, and so on.

Remember, by writing covered calls, one is accepting downside risk on the ETF in return for an "insurance premium" received up front. The only downside protection is the amount of the premium collected. So if you are concerned the market is going to go down, a better approach may be to sell all or a portion of your investment. Additionally, your participation in a market rally will be capped by the strike price, so the strategy is really only appropriate when you have the view that the market is fairly valued and unlikely to move strongly in either direction.

Covered calls on cruise control

Now that we have a feel for how covered call strategies work, let's take a look at the recent product offerings from BMO and Horizons.

Name Ticker MER
BMO Covered Call Canadian Banks ZWB 0.65%
Horizons AlphaPro Enhanced Income Gold Producers HEP 0.65%
Horizons AlphaPro Enhanced Income Energy HEE 0.65%

Banks, gold miners and energy companies are the most prominent segments of the Canadian stock market. As such, the portfolio managers who run these ETFs can deal in liquid options markets with relatively thin bid-ask spreads, thereby reducing frictional transaction costs. Each of the ETFs pays its distributions monthly and rebalances the portfolio semi-annually.

The BMO fund sells call options on an equal-weight portfolio of the six Schedule 1 banks, which by themselves pay solid dividends. After adding call premiums into the mix, this ETF shows a yield of nearly 10%. Income-focused investors who believe the major banks will be range-bound might find this ETF attractive. In fact, ZWB has already gathered more than $112 million since launching on Jan. 28.

The Horizons gold producers ETF (HEP) writes call options on an equally weighted portfolio of the 15 largest and most liquid gold miners. This ETF is an interesting concept, since most gold miners do not pay any dividends. There's plenty of operating leverage imbedded in the mining business, which tends to lead to irregular or lumpy cash flows. Therefore, committing to a consistent dividend policy is a rarity among the miners. This cyclicality we refer to also bolsters the volatility of this group, which means that the call premiums available should be higher than on a sector with lower volatility.

There's a similar case to be made for the Horizons energy ETF (HEE), which also targets a cyclical sector driven in part by commodity prices (oil and gas). Again, higher implied volatility translates into higher call premiums. Like its sibling, this ETF equally weights the top 15 largest and most liquid Canadian energy firms and sells out-of-the-money call options (up to one standard deviation above the current price) to generate extra income.

We should mention one final note on the tax implications of these ETFs. The total distributions are made up of two parts: dividend payments will be taxed as ordinary dividend income, while call option premiums will be taxed as capital gains.

Experienced investors might wish to employ similar strategies on their own to have more flexibility with respect to the expiration dates and strikes of the options. If that's the direction you decide to go, it's always a good idea to check the liquidity of the available options markets and stick with the tightest spreads to help ensure fair execution. Do-it-yourself investors can browse the Canadian Derivatives Exchange to determine which securities in their portfolios would be most appropriate for such strategies. There are size and liquidity constraints for listing options, therefore not all stocks or ETFs have options markets.

Video Reports
More...
Click here to view all