Can you please explain the workings of a product like the Tesla Yield Shares Purpose ETF (YTSL-NE)?
Purpose Investments says this exchange-traded fund is designed to “maximize yield from holding Tesla shares by using a covered call strategy and moderate leverage.” Let’s break that down.
The fund’s core comprises Nasdaq-traded common stock of Tesla Inc., which the prospectus states can account for up to 100 per cent of total assets. But why buy the fund and pay its fees when you can just buy Tesla shares or its currency-hedged, TSX-listed Canadian Depositary Receipts?
This is where the covered call strategy comes in. The managers of the fund sell call options on its Tesla shares, giving buyers of those options the right, but not the obligation, to buy them by a specific date at an agreed upon price, known as the strike price.
If the shares are below the strike price on the expiration date, the options expire worthless – who wants to buy shares for more than they’re worth?
In these cases, the fund gets to have its cake and eat it: It holds onto both the shares (and in a perfect world, any gains) and the premium from the options it sold. In a down market, fund managers talk about covered calls providing a cushion. Your shares are still sinking, but at least you have a bit of income to ease the pain.
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If Tesla shares soar, however, a covered call strategy can limit gains. You still get the premium from selling the options, but you’ll have to unload shares at the strike price.
This is why covered calls can work well for shares trading sideways or slowly upward. You generate steady income from selling the calls, but you can hold on to your shares and profit from capital gains in the future.
The managers of YTSL know this, which is why they apply the covered call strategy to only up to 50 per cent of the fund’s portfolio; the rest is plain vanilla Tesla shares. Well, plain vanilla with a Sichuan chili crisp topping, because they can borrow up to 25 per cent of the fund’s net asset value to buy more Tesla shares. Margin can help to boost returns if shares rise, but it can also magnify losses if they fall.
To recap: YTSL buys Tesla shares, borrows on margin to buy some more and generates income – mostly in the form of tax-efficient capital gains – by writing call options on the shares it holds. Gains on about 50 per cent of the fund’s holdings are capped, but you can theoretically enjoy juiced returns on the common stock. Oh, and the fund is currency-hedged, meaning it tries to smooth out fluctuations in the exchange rate between the loonie and the U.S. dollar.
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There’s one more twist. Despite highlighting the covered call side of its strategy, the fund prospectus says that managers can also write put options, agreeing to buy shares at the strike price if those options are exercised.
As with writing calls, fund managers generate income from option premiums when they write a put, but that premium constitutes the maximum possible return. If I write a put and agree to buy shares at $50, the put buyer won’t want to exercise their option if shares rise above that level, but will be happy to dump shares if they drop toward zero. In other words, the downside for put writers can be substantial, but it can add income in a flat-to-gradually-rising market.
In practice, YTSL has had varying results. It returned a blistering 84.8 per cent last year – well ahead of the 11-per-cent gain of Tesla shares, and also eclipsing the 21-per-cent return of its reference, the Nasdaq 100 Total Return Index. This year, things are looking less rosy. YTSL is down around 14 per cent against a drop of around 2 per cent for Tesla shares and a 16-per-cent gain in the reference index. Tesla’s CDRs are down about 6 per cent.
On the income side, YTSL indicates a distribution yield of 36.1 per cent as of May 6. That’s an impressive number, but given the fund’s structure, it suggests that it’s made possible by sacrificing future capital gains. With Tesla on the rise, Purpose says 93.47 per cent of the fund’s written call options are in the money as of May 1, meaning the underlying shares will probably be called away.
Funds like YTSL – Purpose has similar ETFs available for a range of major American companies – are interesting in theory. They are not a substitute for a more traditional bond or dividend fund, but they may appeal to investors with high risk tolerance looking for a different source of income.
I’d rather hold the shares directly or, as I do, through an index ETF such as the iShares Core Equity ETF Portfolio (XEQT-T).
E-mail your questions to agalbraith@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.