The hefty income flow of covered call ETFs looks like just the thing after recent declines in interest rates and dividend yields.
You’ll have to buy these popular exchange-traded funds without the approval of the adviser community, though. Advisers and financial planners are notably unimpressed by covered call ETFs and prefer more conventional ways to invest for income.
A retired reader who holds covered call ETFs got in touch recently to ask why he never sees these products mentioned in discussions in the financial media about how to generate investment income. To get a sense of how advisers see covered call ETFs, I did a shoutout on LinkedIn that generated mostly negative responses.
Covered call ETFs use an options strategy to generate high levels of income from an underlying portfolio of stocks. Consider a popular pair of ETFs based on a portfolio of bank stocks – the $3.1-billion BMO Covered Call Canadian Banks ETF ZWB-T and the $4.2-billion BMO Equal Weight Banks Index ETF ZEB-T. The distribution yield on ZWB is 6.5 per cent, compared with 3.9 per cent for ZEB.
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ZWB and its peers look like a deal if you’re scrounging for yield after close to two years of interest rate cuts and strong stock market gains that have depressed dividend yields. But recent total returns for both highlight the covered call trade-off. ZWB delivered annualized one- and three-year total returns to May 31 of 19.9 and 6.3 per cent, respectively. ZEB made 27.4 per cent in the past 12 months and 9.8 per cent over the previous three years.
Some of this differential is explained by the fact that ZWB’s management expense ratio of 0.71 per cent far exceeds ZEB’s 0.28 per cent. But the inner workings for covered call ETFs are the biggest factor. These funds are engineered in a way that limits investor participation in gains produced by the portfolio, with potentially less downside in fast-falling markets.
The reader who asked about advisers and covered call ETFs said in an e-mail that he understands how these funds work. He’s fine with the trade-off of yield for total return, as are many other investors who see their portfolios more as machines for producing income mainly.
A similar disconnect exists between many advisers and investors who hold dividend stocks with high yields and modest total returns. Advisers have trouble with the idea of prioritizing income at the cost of a lower total return.
Beyond high fees and lesser total returns, advisers included tax issues on their list of objections to covered call ETFs. These funds tend to pay a mix of dividends, capital gains and a return of capital, which reduces the adjusted cost base for your ETF. There’s a fair bit more complexity here than owning a bunch of dividend-paying blue chip stocks.