Not all enhanced yield ETFs created equal, says portfolio manager

Martin Pelletier agrees covered-call writing features may be worth it in 2022 – but only in certain cases

Not all enhanced yield ETFs created equal, says portfolio manager

As inflation and rising interest rates create a generally inhospitable climate of volatility for the stock markets, 2022 has seen asset managers bring a raft of new enhanced yield strategies to the Canadian ETF space.

Early this year, Evolve Funds and Hamilton ETFs introduced ETFs that provide enhanced exposure to Canada’s largest banks and insurance companies. More recently, Evolve filed a preliminary prospectus to launch two enhanced yield ETFs that provide exposure to the performance of the S&P/TSX 60 and S&P 500 indices.

“Covered-call ETFs account for approximately 15% of the $23 billion in Canadian ETF flows this year," Raj Lala, president and CEO at Evolve ETFs, said in a statement. Last month, Harvest ETFs also bolstered its shelf of offerings with the addition of five new ETFs present mildly leveraged versions of previously launched core equity income strategies.

“We’ve had a 20-plus per cent correction in the market, and we’re facing a challenging macro backdrop,” Paul MacDonald, chief investment officer and portfolio manager at Harvest, told Wealth Professional in an interview following the launch. “So we think it’s a little bit more opportunistic to launch these enhanced strategies now versus earlier in the year.”

Rather than use leverage, this new wave of enhanced-yield ETF products pouring into the Canadian space boost their return potential by using active covered-call strategies on the underlying investments. That kind of approach certainly makes sense in a year like 2022, says Martin Pelletier, senior portfolio manager at Wellington-Altus Private Counsel.

“We’ve traded options for many years, and having an overlay on top of an ETF can be a great all-in-one solution,” Pelletier told Wealth Professional. “We’ve used enhanced ETFs within our toolbox and I think at certain times, it can be a good strategy.”

During times of market stability and complacency, Pelletier says, other strategies like buying put protection may be more compelling as yields on options writing tend to be lower. But an environment like 2022 offers more opportunity for investors to harvest volatility through options writing.

Within his own portfolio, Pelletier says he’s used ZWU, which is a covered-call write on utilities. Compared to consumer discretionary firms whose earnings and revenues tend to plummet during unfavourable market and economic conditions, utility firms are typically more defensive as they offer high dividends and a lower correlation to the broad market.

Pelletier says the sector sold off when the yields on 10-year Treasuries surpassed 4% in September. ZWU is down over 10%, and currently offers an 8.4% yield.

“While enhanced yield ETFs are in our toolbox, we're also utilizing structured notes a lot more,” Pelletier adds, explaining that structured notes are derivative products backstopped by a Canadian bank via a contractual debt obligation. “We see some superior return yields relative to the underlying risk.”

For investors seeking an inflation-beating edge, the returns promised by enhanced yield ETFs certainly may sound enticing. But Pelletier cautions that some of them may be exposed to sectors that are out of favour or facing fundamental challenges.

“I think instead of just looking at the yield in itself, investors should seek out the help of a professional who has derivatives expertise and an understanding of how they work in different markets,” he says.