Trading covered calls with ETFs

10 February 2020 by BMO Global Asset Management
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The search for yield can be difficult and at times force investors to take on more risk than they ought to. Wishing to increase the overall yield of their portfolios, many investors will turn to a covered call strategy.  Done right, this can provide an additional tax efficient stream of cash flow while reducing the overall level of risk. 

Writing one’s own call options can be time consuming and difficult to manage. Luckily, a great deal of innovation has taken place in the ETF space over the last decade, and investors now have a number of covered call ETFs to consider as an alternative. Although BMO ETFs was a pioneer, many other providers have joined this space including Horizons, First Asset and Harvest.

Below are the top five factors to consider when selecting a covered call fund:

1. Not all covered call writing is equal

Each fund provider will run their options strategy in a different manner.

Investors should ask themselves: a) what percentage of the portfolio is “covered” (has calls written on it) and b) how far out of the money (above current stock prices) that calls are generally written at. Some funds might even use leverage to boost the overall portfolio yield.

When the portfolio manager is selling calls on the entire portfolio, this produces a higher yield – but there is a greater chance that the potential upside of those stocks will be capped if the options get exercised.

Options written at or just above current stock prices will provide juicier premiums and may be tempting, but again come with a higher likelihood of getting called away on the stock and capping your upside potential over time.

2. Manager’s track record, experience, and AUM

How many years has the asset manager been running options strategies? What is their level of assets under management? What kind of education do they provide around their strategies?

Scale is important and translates to cost savings shared with investors in the forms of lower trading commissions and better execution due to trade volumes.

3. Fees

Investors should absolutely compare MER’s of the different covered call strategies they are considering. It is normal for covered call strategies to be more expensive than passive index-tracking ETFs, as there is much more time and skill required of the portfolio manager. But even when comparing covered call ETFs against each other, some are quite a bit more expensive than others.

4. Consider the underlying exposure

Let’s say you want to buy an individual stock in a particular sector you feel is poised to do well. Instead of picking one stock, you can pick a sector ETF. If you feel that the long-term prospects are good but the short to mid-term may not be so hot, a sector covered call ETF is a great way to diversify away your individual security specific risk, and get paid to wait at the same time.

Some investors need the additional income that the covered call strategy provides, but are not comfortable taking a concentrated position in or betting on a particular sector. These investors are better served by covered call strategies that hold a diversified basket of dividend stocks.

It is always prudent to look at the underlying holdings and understand what you are buying. Are the underlying holdings companies that typically pay higher dividends? If not, the yield coming from the option premiums will tend to be more volatile.

You also want to make sure, when investing in the US or internationally, that you know whether foreign currency exposure is hedged or unhedged.

5. Transparency is key

Does the issuer of the fund provide info on how the fund is run (% covered, how the stocks are selected)? Is there a full list of the underlying holdings available?

It is important to understand the methodology of the strategy, as well as a view of the underlying holdings. This ensures that there are no unexpected surprises. Most fund companies will provide this information on their websites, so be sure to do your research before.

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms.

Commissions, management fees and expenses (if applicable) all may be associated with investments in mutual funds. Trailing commissions may be associated with investments in certain series of securities of mutual funds. Please read the fund facts, ETF facts or prospectus of the relevant mutual fund before investing.  Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Distributions are not guaranteed and are subject to change and/or elimination.

For a summary of the risks of an investment in the BMO Mutual Funds, please see the specific risks set out in the prospectus.  ETF Series of the BMO Mutual Funds trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss.  Distributions are not guaranteed and are subject to change and/or elimination.

BMO Mutual Funds are managed by BMO Investments Inc., which is an investment fund manager and a separate legal entity from Bank of Montreal.

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