Should you invest in covered call ETFs?

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?

Hi Mark,

I’m interested to hear what you think about covered call ETFs like the BMO products ZWE, ZWC, ZWH.

Thanks!

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:

1. The investor wants cash/income via the premium paid from the call writing strategy.
2. The investor wants to sell a stock/stocks above what they believe are reasonable prices.
3. 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):

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.

Expert feedback

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:

1. 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.
2. They need to be willing to sell the stock at the strike price (or permit the fund to work as designed), which leads to:
3. 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?

Mark

My name is Mark Seed - the founder, editor and owner of My Own Advisor. As my own DIY financial advisor, I'm looking to start semi-retirement soon, sooner than most. Find out how, what I did, and what you can learn to tailor your own financial independence path. Join the newsletter read by thousands each day, always FREE.