Income Enhancements with Covered Call ETFs

By Mark Raes

In today’s low interest rate environment, investors are challenged to generate a sufficient level of income from their portfolios while avoiding additional risk. Savvy investors are recognizing the opportunity to generate more yield from their equity holdings so that they don’t have to extend interest rate risk or credit risk beyond comfortable ranges on their fixed income holdings. Covered call strategies are an effective solution by adding yield with the bonus of reducing equity risk over the long term.

A covered call strategy, also known as a buy-write strategy, writes calls on a portfolio of underlying holdings. The ETF receives a premium by selling the buyer the option to purchase the stock at a later date at an agreed upon strike price. The premium received for selling calls provides additional income and cushion against falling prices, at the cost of limiting upside potential from rapid price appreciation of the holdings.

Not all covered call strategies will produce similar results, as the strategy can be deployed in different ways, based on the percentage of the portfolio that is written on, the time to maturity of the options, and the moneyness of the option.

We recognize it is important to have a lighter touch with the options, to allow the portfolio to participate with rising prices. More aggressive call writing can generate higher income, but will cause the portfolio to miss out on market opportunities. BMO ETFs only write on just over half the portfolio, on short dated calls, typically 1 to 2 months which allows the portfolio to reset to higher strike prices, and out of the money options.

While many investors focus on the call writing strategy, the underlying holdings are just as important. The total return is composed of price appreciation, dividend yield and call premiums, and therefore investors should have conviction in the underlying exposure. In addition, as the ETF receives the dividend yield from the holdings, we build portfolios with higher dividend yields to allow for less reliance on the option premiums while still maintaining a higher yield.

Over shorter time periods, a covered call strategy should outperform the underlying portfolio in flat, declining or moderately rising markets, and may underperform in sharply rising or highly volatile markets, which would cause the strategy to hit the strike price ceiling more frequently. So although more volatile securities pay higher premiums, and may appear to be more attractive call writing candidates, the excess volatility could mean less upside participation in fast rising markets.

While the return over the long term can be expected to approximate the underlying portfolio, the additional income and lower upside means that the return path is much smoother, resulting in lower volatility. Having launched the first covered call ETF in Canada in January 2011, BMO ETFs now has over four years of history that demonstrate the effectiveness of our call writing strategy.

As covered call strategies are difficult and time consuming to run, ETFs are an efficient way to access this strategy. As the benefits of covered call strategies include enhancing income and lowering risk within an asset class, the strategies are very appealing to investors looking to generate more yield without layering on higher portfolio risk.

Mark Raes is Head of Product, Global Structured Investments, BMO Asset Management Inc.