Why high dividend covered call ETFs make perfect sense

This article will discuss the basics of covered call ETFs, how they work, and the associated advantages (and risks) that come along with them

Why high dividend covered call ETFs make perfect sense

Updated 10-18-2023

Because of the realities in the market nowadays, client portfolios must be flexible. With numerous trade disputes and a possible market shock or downturn, client portfolios must adapt to these realities.

One way of making sure that these client portfolios are versatile enough is by allocating assets to high dividend covered call ETFs.

Benefits of covered call ETFs

The main benefit of these covered call ETFs is that they can easily make use of the fast-changing environment of the market. “One of the main benefits is that covered call ETFs are able to harness the volatility inherent in global equities in order to generate yield,” Alain Desbiens says. Desbiens is the Director, ETF Distribution at BMO GAM.

An additional benefit of covered call ETFs is the way they bring in returns. “Another key benefit is related to the fact that the equity recovery is now 10 years in. While on balance the global economy is strong, it’s likely that forward returns over the next couple years will not be as high as prior returns. Covered call strategies are ideal in a modest bull market environment,” Desbiens says.

That’s why for Desbiens, allocating assets to covered call ETFs makes perfect sense in the current environment.

High dividend covered call ETFs are also low cost, low beta, tax efficient, and transparent – things that investors usually look forward to. “The portfolio methodology is explained clearly and 100% of portfolio holdings are disclosed to investors,” Desbiens says. “We also publish any updates on the strategy monthly on the BMO ETF dashboard. We have the biggest asset base of covered call-options in Canada (over C$5 billion in assets), so investors are able leverage the knowledge and expertise of the BMO ETF team.”

Risks in engaging with covered call ETFs

Although it may seem beneficial at most, covered call ETFs come with some risks.

Desbiens explains that the biggest risk is the trade-off between generating return while potentially sacrificing upside return. “It means the portfolio management team has to manage this trade-off prudently, through our methodology, to ensure upside participation is strong,” Desbiens says.

“They stick to 50% portfolio coverage and utilize ‘out of the money’ (OTM) options, so that underlying equities have the potential to appreciate without being overly hindered by the call options. They are not greedy for yield, which would compromise potential upside, but target a modest 2-3% yearly increase in incremental income from selling of call options,” Desbiens added.

What are covered call ETFs?

Covered call ETFs are funds that are listed and traded on a stock exchange – by the very use of the words “exchange traded fund” or “ETF” for short. It can also be bought or sold similar to that of a stock.

It uses a strategy called “covered call writing” which generates yield – in the form of premiums – for its investors by selling call options on a security they own. This premium becomes the additional income generated by this process.

Another way that these funds can generate additional income for their investors is when it invests in a portfolio of stocks, and in turn, uses the covered call writing strategy on a portion of their portfolio. Here, it also provides additional exposure to the underlying stocks in the portfolio.

Watch this video to know more about the basics of covered call ETFs and why has it become popular in the current market:

Is a covered call ETF good?

Aside from boosting investor income, there are many benefits when one engages in a covered call ETF. It reduces investment risk and offers similar advantages that other types of investments have, without its risks.

It also serves as another alternative for investors who are looking for additional investments in their portfolios.

Below are other benefits that makes these funds beneficial for investors:

Higher returns

One of the greatest advantages of covered call ETFs is that they generate higher yields for its investors. They provide consistent returns by selling call options on the underlying stocks in the portfolio.

This makes them popular with investors who would want to supplement their other sources of income by looking forward to the cash flow generated by covered call ETFs.

In addition, due to the nature of a call option, it’s given that its value increases even in a strained or unstable market.

Lower volatility

When the current political and economic environment becomes unstable, it usually affects stocks and investments. However, covered call ETFs persist during these periods while still taking in profits.

In other words, it is less “volatile” than the market because of its increased return when the market itself experiences sever volatility. It can be attributed to the different approach or strategies of covered calls that are considered less “volatile” than the market itself.

Volatility measures the price fluctuations of securities, derivatives, or other investment funds by using standard deviation (or other methods).

As such, buyers in a call option have the security benefits without taking any downside risks.

Different system of returns

Covered call ETFs have a different stock performance compared to the other forms of investments. However, this different pattern or system of returns is one of its greatest advantages.

During years of positive or optimistic political and economic environment, ETFs will likely slow off as the market moves slowly but consistently.

But when rougher years come in – when there is high volatility or after a market crash – the premiums that these funds yield when covered calls are sold help in reducing loss on the part of the investor.

Attractive to certain investors

Covered call ETFs may be attractive to certain sectors or persons of peculiar circumstances, such as:

  • Investors who are nearing retirement
  • Investors who are more risk-averse
  • Investors who don’t want to learn how to “write” and trade off options

As such, it can be said that covered call ETFs are normally attractive to “retail investors” who prefer to receive a monthly income for their investment.

Simplified cover calls

The world of investments is typically confusing, and covered calls are not saved from being a complicated investment strategy. However, with ETFs, it simplifies the whole process of covered calls.

Process of covered call ETFs

As an overview, below is the basics or the usual process of investing in covered call ETFs:

Shares of a stock are bought, and call options contracts are “written” or sold by fund managers (or “call writers”) to investors.

Investors can buy the call option contract by paying option premiums to the “call writer”. The investor then acquires the right to buy shares at a specific price (also called “strike price”) on or before a specified date (e.g., after a few months). This is how ETFs make money out of the investment.

As to call options, an option holder can elect to exercise the option. Thus, the stock will be called away from the person who wrote the call option.

The process can be repeated to get a result that the parties wish to achieve. The whole process is “covered” because the ETF can be delivered when exercised by the option holder.

What is the best ETF for covered calls?

In no particular order, here are some of the best ETF for covered calls:

  • Global X NASDAQ 100 Covered Call ETF (QYLD)
  • BMO Covered Call Canadian Banks ETF (ZWB.TO)
  • Amplify CWP Enhanced Dividend Income ETF (DIVO)
  • Horizons Enhanced Income Equity ETF (HEX.TO)
  • First Trust TCW Opportunistic Fixed Income ETF (FIXD)
  • iShares Russell 2000 ETF (IWM)
  • BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF (ZWA.TO)
  • Invesco S&P 500 BuyWrite ETF (PBP)
  • CI First Asset CanBanc Income Class ETF (CIC.TO)
  • Global X S&P 500 Covered Call ETF (HSPX)

When is the best time to buy covered call ETFs?

Generally, there is no specific time to buy covered call ETFs. In other words, any time will do.

However, there are specific instances that may be advantageous to investors. One of which is when there’s a “sideways drift” of the securities held by the ETF. Also called “horizontal trend”, this occurs when the market supply and demand are nearly equal with each other.

On the other hand, it is not advisable to buy these funds when stocks are generally rising and when stocks regularly reach record highs.

How are covered call ETFs taxed in Canada?

Under Canada’s taxation, covered call ETFs are taxed through the “option premiums” it receives. Option premiums are the income generated by the process of selling call options on the underlying stocks in the investment portfolio.

These option premiums are then considered as short-term capital gains, which are taxed as ordinary income at the investor's marginal tax rate. This makes them tax efficient compared to the other forms of investments.

Are covered call ETFs risky?

As with any other investments available in the market, covered call ETFs are risky but not without any solution. As such, even if these investments can generate income through the sale of call options, their value may still decline if the overall market declines.

Actively managed

Another considered risk of covered call ETFs is that it must be actively managed. This means that they will have higher management or expense costs compared to passive ETFs. However, these costs can be potentially compensated by the extra income or yield generated by these ETFs.

Risks of options

How options increase or decrease in value may also affect covered call ETFs. When the value of the underlying stock falls, the investor may receive shares which are worth less than the previous value of the investment.

Thus, there is a loss on the part of the investor when there is an increase in the underlying stock’s price, the ETF may have to sell the stock at the strike price.

Buyer’s liability

The buyer’s liability in the contract selling a call option may also be considered as one of the risks in covered call ETFs.

Under the law, the transaction of selling or buying a call option is done through a contract. The risk is when a buyer does not pay for the underlying stock being sold or does not fulfill any other conditions agreed upon. However, as with any other contract, the offended party may pursue legal actions against the party violating the contract.

Do you have questions regarding covered call ETFs? Ask us in the comment section below.