ETF Investing

Many covered-call ETFs advertise yields that change significantly from month to month.
By John Gabriel | 14/03/12

Yield is top of mind for many investors, and has been for the past year or so, according to the asset flow data. But, as we discussed in a recent article, the posted figures don't always tell the complete story.

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.

An understanding of the different yield measures is key to avoiding poor investor outcomes. For example, consider an investor who bought a given ETF to help meet her long-term financial goals, because she was enticed by the 10% annualized yield posted by the fund company. Imagine the disappointment she would feel if she were to fall short of her goal because the actual yield she earned over the life of her investment was more like 5%.

Don't be duped by eye-popping yields that are unsustainable. There is often great variability in the distributions paid; a large payout one month could be followed by a tiny distribution the next month. Therefore, simply taking one month's distribution and multiplying it by 12 to get an "annualized" number can be extremely misleading.

A great (and probably the most egregious) example of this is the recent wave of covered call ETFs. These ETFs tend to make monthly distributions, which can be a combination of dividends and premiums collected by writing covered call options. Option premiums make up the majority of distributions, and can vary greatly from month to month with the ebb and flow of implied volatility in the markets.

Take, for example, Horizons Enhanced Income Gold Producers HEP. If you bought in following HEP's distribution in September 2011 based on the eye-popping 26% "annualized yield," you might have been scratching your head as to why that yield was almost cut in half to 14% after the December 2011 distribution. Remember that the market has an inverse relationship with volatility; that is, volatility tends to spike as the stock market drops.

Back in September 2011, rough sledding for stocks coincided with a jump in volatility, which bolstered the option premiums collected from the covered calls. By December, however, the markets had calmed and moved into "rally mode," which has persisted until now. The sharp drop in volatility that accompanied the market's recent rally translated into smaller option premiums collected by the fund. The wide variance of market volatility explains how HEP's estimated annualized yield could drop from 26% to 14% in a matter of just two months.

Investors can ensure they don't get caught off guard by understanding the composition of a given ETF's distribution before allocating any capital. That is, how much of the distribution comes from underlying dividends versus covered call premiums? This will vary based on the fund, as well as the ETF provider. While they all share the same concept of selling future upside exposure in order to generate current portfolio income, there are significant differences in the methodology employed by each provider.

There are varying degrees of implementation across the providers, which influence the risk/return profiles of the respective ETFs. For example, Horizons' suite of covered-call ETFs attempts to generate as much income as it can by writing call options on 100% of the portfolio securities. The idea is to maximize the current income of the portfolio. But, the tradeoff is that the portfolio's upside, in terms of capital appreciation, is capped by the strike price of the option. Eden Rahim actively manages the Horizons products and, according to market conditions, determines the time to expiry as well as how far out of the money to write the call options.

BMO's covered call ETFs reserve the right to write call options on 50% to 100% of the portfolio, which leaves a little bit more room for the funds to participate in capital appreciation when markets rise rapidly. The manager of BMO's funds also has some discretion as to the timing and strike of the call options. When implied volatility in the market rises and drives up option prices, BMO will write the options further out of the money. This allows them to maintain a similar portfolio yield, while also raising the ceiling on the fund for capital appreciation. The opposite is true when implied volatility is dropping: the fund will write its strikes closer to the money to collect bigger premiums, as the market anticipates lower potential for outsized moves. BMO typically writes its options one or two months from expiration.

Finally, there's XTF capital. Canada's newest ETF provider only writes options on 25% of its covered-call ETFs' portfolios. Compared to the other providers, XTF follows a more transparent rules-based strategy. By limiting the covered calls to 25%, the XTF funds will capture at least 75% of the upside if markets were to jump sharply higher. The covered calls are sold at the money (at, or very close to the current market price) with about 30 days to expiration. In our view, XTF's methodology is most suitable for investors who want to boost their yield slightly, but aren't willing to forfeit too much of their upside.

There you have it. Not all covered call ETFs are created equal. We hope that by understanding the different dynamics of how these funds operate, investors can more easily identify, and confidently select the most suitable product.

Where do you fall in the spectrum? An investor whose main priority is current income and who is less concerned with market appreciation will probably lean toward the Horizons funds, which write covered calls on the entire portfolio. At the other end of the spectrum, investors who would like to maintain their upside market exposure while earning a little extra portfolio income will most likely side with XTF Capital's ETFs.

Also, those looking for less variability in the distribution from month to month should stick with an XTF covered call product. Since it only collects premiums on a quarter of the portfolio, the month-to-month swings should be relatively muted. On the other hand, the Horizons funds earn a larger portion of their distributions from the call premiums. Somewhere in the middle sits BMO. One product or methodology isn't necessarily better than the other, but rather, it simply boils down to individual investors' objectives. Choose wisely.

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