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I am interested in your take on using covered-call exchange-traded funds in a tax-free savings account. I understand that in taxable accounts the high current yields ultimately create deferred capital gains tax liabilities through return of capital distributions. This shouldn’t be the case in a TFSA, leading to attractive total after-tax returns. Do I have this right?
Yes. There are no taxes on any type of investment income – including dividends, interest and capital gains – in a TFSA. In a non-registered account, on the other hand, you would need to subtract any return of capital distributions from your cost base. This would create a larger capital gain (or smaller capital loss) when you ultimately sell the investment. Because there are no capital gains taxes in a TFSA, adjusting your cost base is not necessary and no taxes will come into play when you sell your covered-call ETF.
That’s the good news. The bad news is that, in general, covered-call ETFs have lagged their plain-vanilla counterparts.
Consider the BMO Covered Call Canadian Banks ETF (ZWB-T), which posted an annualized total return of about 13.4 per cent for the five years ended Aug. 31. Sounds pretty good, right? But it pales next to the BMO Equal Weight Banks Index ETF (ZEB-T), which doesn’t use covered calls and returned an annualized 18.4 per cent over the same period. (Both return figures include dividends and assume they were reinvested.)
Why such a large performance gap? ZWB’s higher management expense ratio of 0.71 per cent, compared with 0.28 per cent for ZEB, explains part of the difference. But a much bigger factor is the covered-call strategy itself.
Covered-call ETFs such as ZWB generate income by selling call options on a portion of their portfolio. These call options give the option buyer the right to purchase a stock at a specific price before a certain date. (The word “covered” refers to the fact that the ETF owns the stocks on which the options contracts are written, as opposed to a “naked” call in which the option seller does not own the stock.) The premium income from selling call options allows the ETF to enhance the distribution paid to unitholders.
That’s why ZWB can pay a distribution yield of about 5.8 per cent, compared with about 3.3 per cent for ZEB. Many investors find it hard to resist such a fat yield, as evidenced by the nearly $3.5-billion of assets that ZWB has under management. What some unitholders don’t appreciate, however, is that the outsized yield comes at a price.
In a rising market, covered-call ETFs typically underperform non-covered-call strategies. That’s because, when a stock rises above the “strike price” of the option, the option holder will exercise the option to buy the stock. The covered-call ETF still gets to keep the premium income, but it is forced to sell the stock at a price below the market.
In effect, when you purchase a covered-call ETF, you’re giving up some potential future gains in exchange for receiving slightly more income now.
In some cases, selling call options works to the ETF’s advantage. When the underlying stocks are stable or fall in price, the option buyer has no incentive to exercise the option and the ETF simply pockets the premium. That’s why covered-call ETFs perform best, relative to plain-vanilla ETFs, in flat or falling markets.
But given that markets tend to rise over time, writing calls can be a costly strategy over the long run. If you had invested $10,000 in ZWB 10 years ago, today your investment would be worth about $27,491.76, assuming all distributions were reinvested. Had you put $10,000 into ZEB instead, you’d have $36,878.
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My partner and I own stocks, ETFs and guaranteed investment certificates in our registered and non-registered accounts. I am 69, and he is 72. I just started receiving Old Age Security and Canada Pension Plan benefits last year. I am still working part-time, but sometimes need to sell investments to pay for large-ticket items such as travel. I draw on my TFSA or occasionally the non-registered account. My question is: Should I sell stocks or ETFs that have taken a hit, or should I sell investments that have made a gain? Or perhaps a bit of both? Or perhaps sell the investment with the lowest dividend?
Just as there is no simple rule of thumb for deciding which stocks to buy, there is no easy formula for determining which securities to sell. The decision depends on several factors, including the company’s prospects, the stock’s weighting in your portfolio, the income it generates and the tax consequences, if any, of selling.
At the risk of stating the obvious, if you’re pessimistic about a particular company’s outlook, that would make it a candidate for sale. The case for selling would be even stronger if it would trigger a capital loss in a non-registered account, as you could use the loss to offset capital gains and reduce your taxes. (Even if you have no capital gains in the current year, you can carry losses back up to three years, or forward indefinitely, to offset gains in other years.)
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Selling a winning stock in a non-registered account is more problematic, as it would trigger a taxable capital gain. But if the stock represents a very large position in your portfolio, trimming it back could make sense from a risk management standpoint. Generally, however, I’m reluctant to sell companies – such as Canadian banks – that have a long track record of strong capital growth.
Similarly, I’m less inclined to sell companies that generate a high – and growing – stream of income. However, if a company’s yield has shot up into the high single digits because of a falling share price, it’s often a sign that the dividend is in jeopardy. I’ve sold several stocks in the past – including Algonquin Power & Utilities Corp. (AQN-T) and BCE Inc. (BCE-T) – that later took a hatchet to their dividends.
Knowing which stocks to sell is an imperfect science, and you aren’t always going to get it right. But if you focus on selling your weakest companies, minimizing your taxes and hanging on to your long-term winners, you’ll probably make out just fine.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails, but I choose certain questions to answer in my column.