Yielding attraction

Yield is a Rorschach test for investors. Where one see opportunity in high payouts from an investment, another sees high risk.

Consider bonds: yields are moving higher, which implies higher risk in the market, but to an investor considering buying a bond, higher yields represent higher income.

For most of the past 18 years, bond yields have been near historical lows and investors have sought alternatives.

“Canada’s population is aging, with a growing number of investors approaching or entering retirement and looking for more income,” says Pat Sommerville, co-chief executive officer of Hamilton ETFs in Toronto.

Many sought dividend stocks, which involve stock market risk in exchange for higher yields.

“Traditional sources like bonds and even dividend-paying stocks often don’t generate enough income on their own for what some investors are looking for,” he adds.

The yield quest has led to industry innovation, notably the rise of exchange-traded funds (ETFs) using covered call option strategies.

Once a boutique strategy, covered calls have become popular as ETFs. If you are a do-it-yourself investor, they are hard to miss.

Canada has more than 300, ranging from those writing calls on the S&P 500 to sector ETFs like technology to more aggressive products writing calls on a single stock held inside an ETF, involving 25 per cent leverage.

Hamilton is the leading provider with more than $13 billion in assets under management across 20 covered call ETFs.

Here’s how they work: other investors buy the options, paying the ETF a premium for the right to purchase the underlying investments (like a stock) if their prices surpass the agreed-upon price over a set period of time in the future.

If the assets exceed that “strike” price, the owners of the options can purchase the assets from the option seller at the agreed upon price.

In turn, the option buyer can then sell the assets at the higher market price for a profit.

Writing covered calls is a viable income strategy because option sellers receive the premium that can generate at least as much as a dividend yield, often more, and generally, the assets on which the call options are written do not surpass their strike price frequently, especially in slow-growing market conditions.

Also of note, the greater the price volatility of the underlying asset (i.e. a technology stock), the higher the premiums earned from writing call options.

Some covered call ETFs, for example, involving tech stocks have close to 30 per cent annual yields — though these generally involve leverage, borrowing 25 per cent to boost exposure and potentially income.

Winnipeg portfolio manager Alan Fustey, with Bellwether Investment Management, has run covered call strategies for clients in the past. He notes these ETFs can be useful for generating yields outpacing inflation.

But it’s important investors grasp the strategy can involve writing calls “very close to existing pricing to give up as much upside as possible, so that they get as much cash as possible in the form of the premium.”

The risk is investors may not see much, if any, capital appreciation should the underlying assets increase in value, he says.

But many investors are comfortable forgoing upside in exchange for high monthly payments, says Paul MacDonald, president and co-chief investment officer with Harvest ETFs. “We found people really wanted exposure to high growth and high income in one basket.”

Harvest manages about $6 billion AUM across more than 100 covered call ETFs in Canada.

To still provide some upside exposure, most covered call ETFs write calls on a maximum of 50 per cent of the underlying stocks. That way, investors may still experience capital growth on the underlying assets in a bull market, for example.

Demand is such Harvest recently launched five new high-yield ETFs.

Four are single-stock ETFs, including the Harvest Berkshire Hathaway Enhanced High Income Shares ETF. The ETF provides exposure to the formerly Warren Buffett-led conglomerate.

It involves 25 per cent leverage on the underlying stock, and writes covered calls on up to 50 per cent of the portfolio. Fund companies cannot provide estimated annual yields until a fund has a one-year history.

Its unit price is about $12 with monthly payout of six cents per unit. That is an estimated annual yield of about six per cent (as of Oct. 5).

That is significantly less than another launch, the Harvest Intel Enhanced High Income Shares ETF. It pay a 30-cent monthly distribution per unit. Based on a unit price of about $12.50 (as of Oct. 5), the ETF involving 25 per cent leverage has an estimated annual yield of nearly 29 per cent.

Not all covered call ETFs involve leverage, including Harvest Healthcare Leaders Income ETF.

It is among the longest running covered call ETFs in Canada, holding 20 biotech and health-care companies, with a total return (growth, dividend and covered call premiums) of about seven per cent annualized since 2016.

A four-star rated fund by Morningstar, it should be noted its unit price has decreased over that period, suggesting much of its total return has been paid as income.

For more diversified income exposures, investors can also now choose ETFs that are actively managed portfolios of underlying covered call ETFs.

That includes the recently launched Westcourt Hamilton Yield Portfolio ETF.

It holds about a dozen Hamilton high-yield ETFs, using leverage, across U.S. bonds, technology, health care and Canadian banks among others. (It is sub-managed by Westcourt Capital, a high-net-worth advisory firm experienced at running an active strategy of covered call ETFs across different sectors.)

Another is Harvest’s All-In-One High Income Shares ETF, holding three Harvest high-income covered call ETFs that use about 25 per cent leverage.

While the monthly high income is attractive, these high-yield products entail significantly more risk than traditional income products like bonds and guaranteed investment certificates, Fustey cautions.

Be particularly wary with leveraged covered call ETFs, he adds. “Leverage is great on the way up, but it also amplifies losses on the way down.”

Joel Schlesinger is a Winnipeg-based freelance journalist

joelschles@gmail.com