Should you invest in covered call ETFs?
One of the basic tenants of investing is you can’t (easily) add yield or income to your portfolio without taking on additional risk. While I believe this remains to be true, the products that fall into a covered call ETF strategy might try to tell you otherwise.
Thanks to a recent reader question, I’m going to explore some details with covered call Exchange Traded Funds (ETFs) and give you my answer to the question: should you invest in covered call ETFs?
I’m interested to hear what you think about covered call ETFs like the BMO products ZWE, ZWC, ZWH.
Covered calls 101 – my simple explanation
A covered call is a two-part “buy-write” options strategy in which a stock is purchased or owned and calls are sold on a share-for-share basis. It may also be referred to as “call writing”.
Now, instead of doing this with stocks, covered call ETFs sell (or “write”) call options on a portion of their underlying securities. The call option gives the buyer the right to purchase the shares at a specified price before a specified date.
A more detailed, professional covered call explanation
Actually, from BMO themselves, there is a great PDF that explains the details.
Here is their exact language:
“The covered call option strategy, also known as a buy–write strategy, is implemented by writing (selling) a call option contract while owning an equivalent number of shares of the underlying stock. This is considered a conservative strategy because it decreases the risk of stock ownership while providing additional income; however, it caps upside potential on significant price increases. A call option is a contract which allows the purchaser to benefit from a rise in the stock price over a limited time period.
Each contract has a stated exercise price which is the price at which the purchaser has the option to buy the underlying stock. If the stock price rises above the exercise price, the purchaser will exercise their option. If the stock price falls below the exercise price, the purchaser will let the worthless option expire.
The price of the option will be determined based on the difference between the stock price and the exercise price, the volatility of the underlying stock (where greater volatility leads to a higher price) and the time to expiration of the option contract (where a longer time period leads to a higher price). The covered call option strategy allows the portfolio to generate income from the written call option premiums in addition to the dividend income from the underlying stocks. Historically, covered call strategies have provided a similar overall return to the underlying portfolio with a significantly lower risk level.”
Why do it??
Here are the reasons I can think of, to proceed with covered calls, there are likely more:
- The investor wants cash/income via the premium paid from the call writing strategy.
- The investor wants to sell a stock/stocks above what they believe are reasonable prices.
- The investor believes there is some downsize protection if the market declines.
As per BMO, “covered call strategies tend to outperform in flat or down markets, and underperform in periods of rapid market appreciation.”
This means the covered call ETF options strategy is likely the most effective when the underlying stocks the ETF holds are not very volatile. When the ETF sells a call option, it collects a premium from the option buyer and those premiums allow the fund to pay out additional income.
What do I think?
I’m not yet sold on the benefits of this strategy because while an investor may earn additional income from the options premium, the upside is capped; stock price increases can and do occur above the strike price.
I also think the options markets as a whole are thinly traded, meaning, few buyers and sellers which will influence the fund price movements more.
Third, I’m not sold on the fees by using covered call ETFs. Over the years I’ve been investing as a DIY investor, I’ve learned for the most part lower-cost fund products are the best predictor of future returns. Meaning, beyond investor behaviour which is difficult if not impossible to quantify in the future, lower fees coupled with sticking to a strategy you believe will likely yield the best financial results (i.e., you’ll have an opportunity to make lots of money through a buy and hold approach long-term).
Fourth and finally, when I compare the results of this strategy with some plain-vanilla ETF returns of late, you get the following results (data taken from sites as of end of December 2019):
|BMO ZWB – Canadian Banks||0.72%||14.27%||7.08%||n/a|
|BMO ZWE – Europe High Dividend||0.72%||21.46%||n/a||n/a|
|BMO ZWC – Canadian High Dividend||0.72%||17%||n/a||n/a|
|BMO ZWH – U.S. High Dividend||0.71%||16.66%||11.19%||n/a|
|Vanguard VYM – U.S. High Dividend*
*Disclosure – I used to own this fund
This is not a perfect comparison I know. What I’m seeking to illustrate is from a total return perspective, when we compare some covered call ETFs to some lower-cost dividend ETFs or S&P/TSX indexed funds including BMO’s low-cost leader ZCN, while you’re in the ballpark for investment returns you’re not getting ahead in some cases.
When I discussed covered call ETFs recently with a fellow blogger and former Tangerine advisor, Dale Roberts from Cut The Crap Investing, he coincidentally was doing some digging himself on these products. He cited the following responses from Victor Kuntzevitsky, the VP of Investing & Portfolio Strategy from Northland Wealth Management.
When Dale mentioned the downside risk seems slightly better than the market, Victor responded by saying “yes, just slightly”. Victor went on to add:
“Selling covered calls shouldn’t be viewed as downside risk management as downsize risk doesn’t change materially versus long stock. You would manage/limit downside risk by purchasing puts. Selling calls is mainly a return enhancement.”
When Dale highlighted a covered call strategy (therefore using ETFs in this case) should not suffer a great drawdown effect in a major market correction, Victor responded with caution saying: “the fund can still underperform as it won’t have good upside capture in a sharp recovery”.
Should you invest in covered call ETFs?
Unfortunately I can’t say whether you should or should not. I know this approach does help some investors though.
My bias for my investment journey is to own many Canadian dividend paying stocks for the long-haul. In doing so, I participate in both the market lows (for cheaper dividend stock reinvestments) and market highs (for tax efficient (non-registered), tax-deferred (RRSP) or in some cases tax-free (thanks TFSA!) gains.
By owning Canadian stocks directly, I also pay no ongoing money management fees.
The downside of course to my Canadian dividend investing approach is I may underperform the S&P/TSX index long-term. Time will tell!
In addition to owning about ~ 30 Canadian stocks for income and growth, I also own a few U.S. stocks and low-cost ETFs. I own some plain vanilla ETFs for some income but more price appreciation inside my TFSA in particular.
Your approach to investing may always differ from mine. That doesn’t make it right or wrong whatsoever.
In closing, I think investors who strive to earn income from covered calls or covered call ETFs need to be mindful of the following:
- They should consider holding the stock (or fund) from a long period of time to avoid flip-flopping investment strategies that could harm their portfolio value. This is largely true with any investing approach – you need to mind your investing behaviour gaps to achieve investing success.
- They need to be willing to sell the stock at the strike price (or permit the fund to work as designed), which leads to:
- They need to accept there may be an opportunity cost if the stock price (or prices in the underlying fund) rise considerably, therefore putting a cap on the sale price of the covered call or put a limit on any appreciation value of the ETF.
As an investor then, if you think the market is not going to go up long-term; the market is likely to be volatile and sideways short-term, then maybe covered call ETFs are something to consider for a small portion of your portfolio for the any income boost.
Otherwise, with the complexity that comes with any covered call strategy you might be better off just sticking to plain vanilla ETFs, solid all-in-one ETFs, or established, reputable mutual funds like Mawer among others for long-term wealth building.
Heck, own a few Canadian and U.S. dividend stocks if you wish!
I know for my portfolio, right now, I’m not thinking there is a home for covered call ETFs but you never know.
Thoughts on this post? Thoughts on covered calls as a strategy and the ETFs that embed this strategy? What would you add to this approach that I don’t know about yet?
Brandon Beavis talks about ZWC briefly in this video (https://www.youtube.com/watch?v=n5qPic5LcjU – the last EFT that was discussed): The main goal is about getting dividends from the fund (6-7% average annual dividend, paid out monthly), although the base fund price have some gains as well.
I would suggest:
1) Use it not as a primary fund, but as an additional fund to diversify your investment. There is no need to have 6 or 7 EFTs that simply hold Apple, Microsoft, Royal Bank, TD, etc.
2) Start out small – invest a small amount, see if you like it first.
3) Check out their various other covered call ETFs – they have several.
4) Buy it within TSFA and the dividends will be tax free.
ZWC is an interesting product. The challenge I find with covered call ETFs is they work until they don’t. Yes, you don’t want volatility in the short-term but long-term it works out in your favour as a buy and hold and buy some more investor.
“As an investor then, if you think the market is not going to go up long-term; the market is likely to be volatile and sideways short-term, then maybe covered call ETFs are something to consider for a small portion of your portfolio for the any income boost.
Otherwise, with the complexity that comes with any covered call strategy you might be better off just sticking to plain vanilla ETFs, solid all-in-one ETFs, or established, reputable mutual funds like Mawer among others for long-term wealth building.”
i am 82 and invest for 40 years.i like a bit of RISK.thats where the gains are.buying PUTS orCALLS never worked
for me; i sell only.!!! i only bye stock’s with PUTS, i thing have a future like internet or high dividend and when i lose them
true CALLS , bye them again with PUTS.
Thanks for your comment Helmut.
I know BMO has a few such etfs and I bought into them thinking that coming to the later part of the bull market, these will perform better than regular etfs. The rational is mostly defensive as buying puts cost money while selling calls limit gains. I think it’s the better of thd two options.
It turns out this bull market is having greater stamina than most people believe.
It’s really crazy isn’t it Bill – the bull run? Nobody saw this coming which makes me think whatever is on the other side, could be big and damaging as well. Thoughts?
All the best in 2020.
I could see where this could be a very good strategy for a retiree.
You’ve now FIRED are living off your dividends. The market has been very good but unfortunately you’re overweight in Banks which means you need to re-balance. During your accumulation stage it simply meant buying different stocks, but since you’re no longer working you’re no longer buying anything. So in order to rebalance it means having to sell something. Now rather than selling them directly you begin to write covered calls, earning some extra income till the stock gets called away.
Two downsides I see. One is that the stock continues to climb so you’re leaving profit on the table, but you were planning on selling anyways so no biggie. The other downside is the stock begins to drop, perhaps a market correction, now by not selling you really have left money on the table. On the other hand your portfolio has rebalanced itself.
Second scenario is you are looking for cash. Perhaps you want to help the kids, grandkids with a downpayment. Maybe you like to have 2 years income in cash, or even to take money out to buy that new car or to fund the annual trip to Florida. Again same downside by not selling you risk a market correction.
But to this investor I see the biggest reason for this is simply money. You can add extra yield at very little risk. That as long as you understand that the stock will be called away and the buyer will be getting the capital gain. You could use something like Fastgraphs to determine what stocks are over or under valued. If you feel the stock is overvalued and you don’t want to sell than it can bring in some extra income. For example I bought TD and BMO and according to my research there is some real upside on the stocks 10-15 dollars so obviously I won’t write any covered calls.
Myself my biggest concern is I simply don’t like ETFs, If I were to trade options I want to do this myself not through a fund and it’s bit a of a understatement to say that options can be confusing.
Interestingly maybe Rob, I’m growing more comfortable with owning ETFs going forward since I want to avoid some individual stock risk. Thoughts?
I hope to keep about 1-year worth in cash in about 5 years for semi-retirement. At least that’s the plan 🙂
Thanks Mark for this article,
when i started learning about DIY investing i happened to see those covered call ETFs with their juicy yield but then almost everyone was against them unless you’re in retirement and don’t care about capital growth so i ended up with plain vanilla etfs and so far its been great .
Mark i know you and maybe all your readers are into blue chip stocks but i wanted to ask if you or anyone here ever tried investing in penny stocks ? i have a coworker that does this on daily bases and I’m trying to convince him to switch to a more safer investing strategy but according to him he says he’s making way more money this way ( although he never mentioned his losses but always the time when he made money 🙂
I did invest in penny stocks. Certainly didn’t turn out well for me 🙂
“I bought a couple of penny stock companies in my 20s, hoping they would skyrocket in value over time. These guys never went anywhere but down. I owned one in my account for the longest time as a reminder of the money I’ve lost on trying to cherry-pick stocks that have little to no established history of capital gains or any dividend histories. I only invest in broad market ETFs and dividend paying stocks now.”
I would be VERY skeptical of his “making way more money this way” but that strategy likely works until it doesn’t!
Speaking of penny stocks I nearly dropped a fortune into Penngrowth, thought you couldn’t go wrong. Thankfully I commented about this on Dividend Ninja’s blog and he in no uncertain terms told me not to do it! Anyways fast forward a few years stock when from 10 bucks to about 20 cents. My brother had a few dollars left over so thought, what the heck, bought about 75 dollars worth and well, now he has some tax losses to claim LOL
Penny stocks – bad!! 🙂
Gus hits the nail on the head. In the decumulation phase of life, you care more about cash flow than growth.
Pre-retirement, the goal is to build your portfolio, so low fee growth ETF’s are what you want.
Post retirement, you want a mix which is primarily conservative but contains a modest amount of higher risk investments to improve cashflow and offset inflationary spikes.
In my view, covered call ETF’s trade off growth upside for cashflow stability, but you have to be prepared to ride out periods of higher market volatility when that cash flow stability is disrupted.
So you don’t want them to form more than 10% of your post retirement cash flow.
I agree, I’m building my portfolio now for cash flow such that in 5-years I can semi-retire. At least that’s the plan!
I hope to have a 50/50 mix of dividend paying stocks with some low-cost ETFs that deliver income.
Likely smart stuff to have <10% in covered call ETFs, I do see the merit of that thinking!
Mark – please post a graph showing div’s paid out instead of total return.
If seeking yield, total return doesn’t mean much when you go grocery shopping each month.
@Shredder: +1, it’s the income that counts.
Good point, re: “shopping”.
I can’t speak for this investor but the dividend paid out are available on BMO’s site and other sites that offer these products. Here is an example:
Distribution Period1 Ex-Dividend Date Record Date Pay Date Cash Distribution Per Unit Reinvested Distribution Per Unit2 Total Distribution Per Unit
Jan, 2019 Jan 29, 2019 Jan 30, 2019 Feb 04, 2019 0.085000 0.000000 0.085000
Feb, 2019 Feb 26, 2019 Feb 27, 2019 Mar 04, 2019 0.085000 0.000000 0.085000
Mar, 2019 Mar 27, 2019 Mar 28, 2019 Apr 02, 2019 0.085000 0.000000 0.085000
Apr, 2019 Apr 26, 2019 Apr 29, 2019 May 02, 2019 0.085000 0.000000 0.085000
May, 2019 May 29, 2019 May 30, 2019 Jun 04, 2019 0.085000 0.000000 0.085000
Jun, 2019 Jun 26, 2019 Jun 27, 2019 Jul 03, 2019 0.085000 0.000000 0.085000
Jul, 2019 Jul 29, 2019 Jul 30, 2019 Aug 02, 2019 0.085000 0.000000 0.085000
Aug, 2019 Aug 28, 2019 Aug 29, 2019 Sep 04, 2019 0.085000 0.000000 0.085000
Sep, 2019 Sep 26, 2019 Sep 27, 2019 Oct 02, 2019 0.085000 0.000000 0.085000
Oct, 2019 Oct 29, 2019 Oct 30, 2019 Nov 04, 2019 0.085000 0.000000 0.085000
Nov, 2019 Nov 27, 2019 Nov 28, 2019 Dec 03, 2019 0.085000 0.000000 0.085000
Dec, 2019 Dec 27, 2019 Dec 30, 2019 Jan 03, 2020 0.085000 0.000000 0.085000
I bought a number of etfs, one being zwc. I was thinking of narrowing them down to just two. I had no clue what a covered etf was and am now trying to learn. Yes, I have it backwards. I like the distribution, don’t really care if the price goes up or down as long as it pays out. My question is, can i just sell this like a non covered etf? If it was listed at the price I bought it, would I lose some in the sale due to it being covered? I am struggling to understand what these are all about? I have had it for a short period of time. tks
Fair point about ignoring the ups and downs Wendy – that’s very good actually and what you should do 🙂 You’ll probably need to speak to BMO about that product, how it operates, I don’t know all the details about ZWC.
Be mindful that during bear markets/bad markets, and maybe some modest bull markets, a covered call strategy/ETF “may” (key word!) outperform its underlying securities. During strong bull markets, when the underlying securities may rise more frequently through their strike prices, covered call strategies historically have lagged. During any period, depending on your holding period, using covered call/options investing “may” still earn some capital appreciation, plus any dividends and call premiums – so the fund price could rise over time but nothing is guaranteed…
I recall ZWC has only been around for a few years and it’s still trading some 15% below Feb. 2017 launch levels. Yield is good but so is growth so total return matters.
Happy Investing and HNY!
Thanks Mark for your analysis of the covered call etfs. I’m retired and have some ZWC in my cash account for income, the yield is good but, yes the MER is high for an ETF.
I think that’s the thing. Covered calls are good since you’re paid a premium “to wait” but for that active money management you’re also paying an ETF premium. No real free lunch is there? 🙂
I think Lloyd and Cannew’s take is prudent for most investors … if you are not thrilled with the prospect of understanding how covered calls work, and the conditions within which they are and aren’t beneficial, then I would leave them alone. Never invest in something you don’t fully understand is one practice that everyone should follow (in my humble opinion).
All options, including covered calls, change the risk profile of an investment, as well as adding new costs and new tax issues for unregistered accounts. In some markets this strategy will out-perform, in some markets this strategy will under-perform. One thing you are assured of going into the ETF covered call strategy is that it is more expensive, as is evidenced by the higher MERs. If you are working with a lower MER, you are working with an implicit advantage. If you are going to add cost and complexity to a portfolio it should bring with it a clear and obvious advantage. You need to do some work to determine if that is the case with covered calls in your circumstances or not. Also, the tactics employed by each of the ETF providers is different in terms of how they implement the strategy (term of the option, extent of writing coverage, etc), each product needs to be researched and evaluated, they aren’t all the same.
Personally I have used a covered call strategy at times in the past, though I have never used it in an ETF. Sometimes it worked – the premium earned enhanced my return or reduced a loss (however as pointed out by Mark the downside protection is marginal). Sometimes it didn’t – the call was exercised and I missed out on an excess price movement. In all cases I spent more time and effort managing my portfolio, and more time and effort doing my taxes (which is ok for me because I like this stuff – I’m a bit weird). The ETF approach takes this last piece out of the picture to an extent, but the cost hurdle appears to be difficult to justify based on the returns that I have seen from the ETFs using this model that I have looked at.
Conceptually, I believe there may be some merit in these products once/if the MERs come down, but I’m not convinced that they provide an out-sized advantage as they are currently constituted in the average investors portfolio.
Your point is well taken here Larry that options, including covered calls = risk. While there may be potential return, there is also potential downside. There are also additional costs (trading, money management) and taxation considerations.
I’m not fully against these products, hardly. My own investing approach has risks and trade-offs. But I just don’t feel they have a fit for me right now. Who knows in the future?!
Larry, will be in touch this month about our interview/Q&A!
Being honest, I’ve never looked at them so I don’t know what or how they work and I’m just too GD lazy to learn. They might be the best thing since sliced bread but I wouldn’t know. Much like the MIG welder in the shop. 🙂
Nothing wrong with sticking to your own plan that is working Lloyd!
Depends on where you are in the life cycle.
Post retirement, ETF’s like ZWC with a wide number of holdings provide a steady income stream from an RRSP or RRIF, complementary to one’s primary income streams, with reduced admin burden.
(Do you want to do other things or work your portfoilio frequently?)
So I believe there is a spot for them in the decumulation phase of life.
You are likely a confident and knowledgeable investor and I think that’s important when such products are available – otherwise, you’re getting into a product you don’t understand and may deviate from. That will cost you $$.
As always, “it depends” when it comes to investing. Thanks for your comment.
Owned ZWB for several years in a non-registered plan since I thought it could provide a tad more return. Overall it underperformed the BMO ZEB – Equal weight Canadian Banks ETF and my own bank holdings. The covered call premiums also got taxed as income so after income taxes, the return was even lower.
You strike me as a very knowledgeable investor Colin, and good on you. I would worry about the taxation and the long-term performance personally but for the income boost, seems like a good product for that.
I’ve never used this strategy and therefore can’t offer suggestions if it’s a good or bad choice. Having said that I still believe that if one invests in quality DG stocks one will achieve not only income but a growing yield. Why complicate an already simple process.
Ya, I find it enough “work” to stick to my existing plan without additional things to worry about. I’m really trying to simplify my financial investing decisions going-forward.