Covered Call ETFs deliver less than promise

Posted on: February 27, 2012 in: Canadian Equities, Options with 0 comments

BMO COVERED CALL CANADIAN BA Ticker: ZWB / TSX

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The first covered call ETF hit the Canadian marketplace a year ago and was welcomed by income-seeking investors. Unfortunately, those investors are still seeking.

When covered call ETFs arrived, their timing was perfect. Low bond yields and tumultuous equity markets had scuppered many a retirement plan. Into this income vacuum, products like mortgage investment corporations and limited partnership structures had appeared. Covered call ETFs were a sensible addition.

The tantalizing mix of capital gains and income offered by these ETFs helped them grow quickly. Today, there are 14 such products on the TSX, with total assets of $1.3 billion. Whether they keep growing depends on how well they fulfill their promise.

Here’s a quick review of how they work: An ETF of, say, three stocks writes (sells) call options on the three firms at a fixed “strike” price and for a premium. The ETF collects the premium from the sale. However, if the call option is “in the money” any time before it expires, usually about a month later, it can be “exercised”. That is, if the market price of the stock is higher than the strike price, then the ETF will be obliged to sell the stock for the agreed strike price and then buy it back at the higher market price.

To minimize the chances of being called away, the ETF manager sells call options at a strike price that is higher than the prevailing market price. This works well if stock prices are ticking up steadily and slowly. However, it does not work so well when markets are choppy as they were for much of 2011.

The performance of a couple of covered call ETFs supports the point. The Horizons Enhanced Equity ETF (HEX/TSX) holds 30 large cap Canadian stocks that also have liquid options markets. HEX writes call options on most of its portfolio, usually with a one month maturity and at a strike price slightly higher than the prevailing market price.

Since its start last March, HEX earned dividends and call premiums totalling 11.9%. But its price fell about 21.2%, leaving a net total return of negative 9.3%. With some data from Horizons, I constructed a portfolio of the same 30 stocks on my Bloomberg, taking into account the rebalance last September. This plain portfolio returned 12.0%, suggesting HEX’s call income added 2.7 percentage points. That is good but a lot less than the income investors were expecting from writing calls.

Another is the BMO Covered Call Bank ETF (ZWB/TSX), which, conveniently, has a comparable, uncovered companion, the BMO S&P/TSX Equal Bank Index ETF (ZEB/TSX). As the first covered call ETF on the block, ZWB has been an incredible success, having gathered over $730 million since its launch last February, while plain ZEB has $430 million though it has been around longer.

Unlike HEX, ZWB writes call options on only about half its portfolio. The balance is invested in plain ZEB. In the last 12 months ZWB fell by 8.5% but dividend and call writing paid 9.1%, leaving a net total return of 0.57%. Plain ZEB fell only 1.4%, but with dividends of 3.5%, earned a total return of 2.1%. Again the plain version beat the covered.

Why the mediocre returns for both HEX and ZWB? In last year’s choppy market, their shares were repeatedly called away and then bought back at a higher market price, thus hurting capital gains.

One argument in favor of call writing is it helps smooth returns, especially in choppy or falling markets. But as we’ve shown, in last year’s Edmund-Fitzgerald-esque markets, call writing in one case somewhat helped and in the other, actually hurt returns. True, both the covered call ETFs have slightly lower volatility than the plain versions but not enough to be meaningful.

The other disadvantage of some covered call ETFs is that, essentially, they convert capital gains into current income, something that pleases no one but for the CRA and builders of Muskokan gazebos. HEX avoids this by classifying its call writing income as capital gains for tax purposes. But regardless, you are still eating tomorrow’s lunch today.

Are there times when it makes sense to own covered call ETFs? If you knew that markets would rise slowly but steadily over the next year or so, then that would be a great time to own a HEX or a ZWB. But if you really, truly knew that, then there are better ways to make even more money.

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Chart courtesy of Bloomberg L.P. Click on Chart for Larger Image

archerETF Metrix 27 Feb 2012
Ticker/Exchange ZWB / TSX
Name BMO COVERED CALL CANADIAN BA
Categories Canada/Equity/Financials/Alternative
Total Holdings 6 Bank Stocks + Call Options
52 Week High 16.74
Recent Price 14.33
52 Week Low 12.78
Avg Daily Volume 296,694 shares
Avg Daily Volume ($) $ 4.3 Million
Total ETF Assets $ 753.8 Million
Allocation to 10 Largest Holdings 100.00%
ETF Annual Fee .65%
ETF Trading Currency CAD
ETF FX Exposure CAD
Annual Volatility 16.20%
Correlation to S&P TSX Comp. 78.90%
Return to Risk Ratio N/A
Beta to S&P TSX Comp. 0.75
Price-to-Earnings Ratio 11.36
Use of Leverage No
Use of Futures YES – Call Options
6 month Return 8.16%
1 Year Return -.95%
3 Year Return N/A
Dividend Yield (TTM) 9.44%

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© 2012 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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