Why is dividend investing an attractive investing strategy? The main attraction, I think, lies in the idea of living off dividends, being tax-efficient, and not touching your principal. By not touching the principal, many investors believe dividend investing provides more margin of safety and allows them to sleep better at night.
This is valid logic but one must also consider geographical and asset diversification. This is one of the key reasons why we invest in index ETFs like the iShares ex-Canada ETF, XAW. But that’s another topic for another day…
Recently a reader asked whether we invest in high yield covered call ETFs. Given that many of these covered call ETFs have very high yields, the reader wondered why we don’t use them to increase our dividend income and expedite our financial independence journey.
Should we invest in covered call ETFs?
Higher dividend = higher risk
One important thing to know is that you cannot arbitrarily increase yields without taking on additional risks. In order to pay dividends to shareholders, companies must have the money. If a stock has a very high yield, it typically means the company passes most of its earnings to shareholders rather than retaining and reinvesting the earnings into the company for further growth.
Interestingly, if you look at the details of the high-yield covered call ETFs, most of them use keywords like “high quality,” “mitigating downside risk,” “attractive monthly distributions,” “total return,” etc. It is almost as if these covered call ETFs are extremely safe and the high yields do not add more risks.
Is this true?
Before I dive into that question, let’s go over some terms for options trading.
Options 101 – What is a covered call?
In options trading, there are two things an investor can do – put and call.
A put option is a contract that gives the buyer the right, but not the obligation, to sell a specific amount of an underlying security at a pre-determined price (strike price) within a specified time frame (expiration date).
Put option buyers profit when the security price falls below the strike price and before the option expires.
Put option sellers collect a premium upfront. The ideal situation for a put option seller is that the security price will stay flat or rise above the strike price before the expiration date, making the put option worthless.
To learn more about put options, check out this article by Bankrate.
A call option is a contract that gives the buyer the right, but not the obligation, to buy a specific amount of an underlying security, like stock, ETFs, or commodities at a specific price within a specific time period.
One would typically buy a call option when one believes the underlying security will increase in price before the option expiration date.
A call seller makes money upfront by collecting a premium. If the security price stays flat or declines, the option contract expires and the call seller makes money from the option premium.
Since options simply give you the right to sell or buy a specific amount of asset within a designated time frame, you don’t necessarily need to own the underlying asset. Therefore, we also need to cover the terms “naked” and “covered.” Naked options mean that the investor does not own the underlying security, while covered options mean the investor already owns the underlying security.
To learn more about call options, check out this article by Bankrate.
How to increase yield by using covered calls
When you sell a call option, you get paid a premium. On the day the contract expires, if the stock price is below the strike price, the contract expires and you not only pocket the premium, you also get to keep your shares.
If the stock price is above the strike price, the call option buyer will exercise the option. When this happens, you are obligated to sell your shares to the buyer at the agreed strike price.
For a covered call, since you already own the shares, you just sell the shares to the buyer and pocket the money. If it were a naked call, you’d have to buy the shares in the open market, typically at a higher price than the strike price, then sell the shares to the call buyer at the strike price. In other words, you will incur a loss (i.e. your “buy” price is higher than the “sell/strike” price). This is why selling covered calls are generally safer than naked calls.
How do these ETFs increase yields by using covered calls? Well, they increase the distribution yields by selling covered calls, collecting the premiums, and distributing part of the premiums to shareholders.
Is it a win-win?
Because of its nature, covered calls tend to perform better in flat or down markets, because the call options typically won’t get exercised. However, when the market is hot or the stock price goes for a wild ride, covered calls will often get exercised, resulting in poor performance for cover call sellers.
So, it is more effective to utilize covered call options when the market is not very volatile.
Covered call ETFs typically already own a handful of stocks. The fund managers then sell covered call options to collect premiums. These premiums and the stock dividends are passed down to the shareholders, resulting in higher dividend yields.
But don’t convince yourself that this is a win-win situation.
As mentioned, not every covered call option ends up expiring. Due to better than expected earnings or good news, the stock price can jump suddenly before the option expiration date. So, some options will get exercised and the fund managers will need to sell stock shares.
When options are exercised, the fund company needs to declare capital gains or losses, resulting in tax consequences. The fund managers also need to buy back the stock shares to ensure the ETF meets the underlying equity holding percentages.
For example, say the fund is maintaining a 5% exposure to Royal Bank and the fund just sold a considerable number of RY shares because call options were exercised. In this example, the fund managers need to buy more RY shares at market price to meet the 5% exposure. All this selling and buying means a higher management expense ratio (MER) – and thus money out of the investor’s pocket.
Furthermore, while the yields might look nice, it is highly likely that most of the yields come from capital gains (referred to as ‘return of capital.) Investors won’t be able to utilize the favourable dividend tax credits and may have to pay capital gain taxes on a portion of the distribution. If we look at the tax breakdown of ZWG, we’ll notice that in 2020, 28.28% of the distribution was from capital gains and 36.21% of the distribution was from the return of capital. Only 4.67% of the distribution was from eligible dividends.
While dividend income is important, I believe dividend investors should care about the overall portfolio return, regardless of whether they plan to sell principal or not. The total return approach gives investors more flexibility because they can sell a small portion of their portfolio to supplement dividend income.
With the total return in mind, I am not convinced that the high yield covered call ETFs will perform better than low-cost passive index funds like VCN and VXC or dividend ETFs like VDY over the long term. Below is a comparison.
|ETF||MER||Yield||3-Year Return||5-Year Return|
This is not a very scientific comparison but for these covered call ETFs, it appears that you may be trading a higher dividend yield for a lower total return.
To make things more confusing, rather than holding stocks directly and selling covered calls, some covered call ETFs hold a selection of various covered call ETFs. For example, Hamilton Enhanced Multi-Sector Covered Call ETF, HDIV, holds a mix of various covered call ETFs and income ETFs like NXF, FLI, ZWB, HTA, ZWU, HHL, and HEP. It is extremely difficult to understand the specific underlying securities HDIV holds.
HDIV’s approach is very similar to the all-in-one ETFs and the all equity ETFs like VEQT, XEQT, and HGRO that Vanguard, iShares, and Horizons offer. The key difference? The likes of Vanguard, iShares, and Horizons construct these all in one and all equity ETFs by holding company-managed ETFs; HDIV uses non-Hamilton covered call ETFs. (Also, a major difference is that HDIV uses what they term a “modest leverage” of 25%.)
Should I invest in high yield covered call ETFs?
We don’t own any high yield covered call ETFs, precisely because of what I have written. We prefer owning individual dividend paying stocks and low cost passive index ETFs to keep a simple dividend portfolio and build our dividend income accordingly.
Does that mean you shouldn’t invest in covered call ETFs?
Well, it depends.
If you are close to retirement or already living off your portfolio, covered call ETFs might be an effective way to increase your overall investment income and not have to withdraw as much from your portfolio.
But if you are still in the accumulation phase, I believe you’re better off owning individual dividend stocks or index ETFs. If you decide to boost your investment income once you’re more experienced, you can always consider selling calls or puts and collecting dividends. Liquid from Freedom 35 started selling options and has done well. You may want to look at this guide if you want to explore earning options with dividend stocks.
I know many dividend growth investors sell covered calls or covered puts to increase their passive income. We haven’t done that because it becomes more speculating than investing. Furthermore, I don’t have time to do the research required to execute calls or puts.
Please note, I’m not saying that you should just stay away from covered call ETFs. These covered call ETFs are created because there are demands. It is the same reason why preferred shares ETFs, split corp funds, or income trust funds were created. We shouldn’t just flat-out reject them and never consider investing in them. It is important to see them as yet another tool in your toolbox that you can use to construct your portfolio.
Having said that, be careful with having a too high concentration of covered call ETFs, high yield low growth dividend stocks, income trusts, and split corp in your investment portfolio.
Remember, the higher the yield, the higher the risk.
Manage your risk!