The facts about covered call options

We live in a world of non-existent yields, with central banks manipulating interest rates. When higher yields do surface, they tend to be accompanied by a failure to alleviate significant concerns regarding debt levels and refinancing for specific countries—take Spain and Italy.

For investors, the choices aren’t all that appetizing: get close to zero yield; or get a higher yield, but with a meaningful dose of added risk. Against this backdrop, Canadian ETF investors are choosing ETFs that provide access to cash flows generated by REITs, and dividend stocks.

Beyond this, fund providers are resurrecting a product strategy long associated with closed-end funds — covered-call writing. This involves selling somebody else the option to buy a stock you already own, at a set price, for a certain period. Many advisors use it on individual stock positions — typically where they see limited near-term upside potential for a stock, and/or seek a way to generate some additional cash flow.

Market methodologies

At a recent webinar, we dissected covered-call ETF methodologies used by BMO, Horizons, and XTF Capital. We found BMO ETFs experience significant success in terms of AUM growth with their Covered Call Banks (ZWB) ETF, while Horizons has the broadest selection of covered-call ETFs. On the other hand, XTF Capital Corp’s closed-end fund sister company, First Asset, manages covered-call strategies for AUM significantly greater than those currently found in their ETFs offering (see, “Comparative analysis,” below).

Comparative analysis

All three use a distinct methodology when dealing with their covered-call ETFs (% level of call writing on the portfolios; strike prices at which options are written). The underlying portfolios comprising the covered-call ETF product offering do not involve active stock selection, and are equally weighted across their underlying portfolio constituents (rebalanced according to the methodology stipulated in their offering).

Covered-call ETFs pay what they generate, with no set distribution levels. This avoids a structural problem encountered by covered-call writing strategies using closed-end funds, which earlier experienced significant NAV erosion as a result of fixed distribution policies.

Sampling choices

Our experts referred to the performance of covered-call ETFs in a total-returns context. This is critically important, particularly for 100% covered-call-written Horizons ETFs. In order to fully benefit from the strategy overtime, an investor would have to reinvest distributions to achieve these total returns (market returns but with lower risk). If retail investors fully spend the cash flows in question, they cannot expect to achieve returns “comparable” to those calculated on a total-returns basis.

Changing yields through changing volatility

Risk Factors

Covered-call writing provides some cushion against potential downside risk (the premiums received). That said, investors need to appreciate they are still exposed to the equity risks of their respective covered-call ETF.

In addition, they also need to understand that sector- or commodity-based ETFs likely entail greater volatility than that of a broader-market ETF. On the flipside, their upside participation profiles are also modified/reduced.

Covered-call ETFs hold the appeal of a higher-yielding product, with lowered risk relative to straight equities. The trade-offs of a call-writing strategy need to be kept in mind when comparing the ETFs’ returns with market or total returns.

Yves Rebetez, CFA, is managing director and editor of ETFinsight.