Why Canadian Investors Are Turning To High-Yielding Covered Call ETFs For Cash-Flow

Over the years, Canadian investors have increasingly embraced covered call exchange-traded funds (ETFs) to navigate stock market volatility, the rising cost of living and retirement plans. At last check in the latter half of 2023, covered call ETFs were the third-most popular ETF category in Canada in the year, according to data from TD securities – attracting $3 billion in new assets. 

The principal reason driving this trend is that covered call ETFs, such as those offered by BMO Global Asset Management, allow investors to generate additional cash flow through option premiums while carefully managing risk. In essence, investors are able to boost their cash flow and mitigate volatility in their equity portfolio by capitalizing on a popular option strategy that traditionally requires a high level of technical expertise to implement.

Understanding Covered Calls

A covered call is an investment strategy where an investor holds a stock and sells a call option on the same stock. This approach is ideal for markets experiencing minimal price fluctuations. It provides a hedge against minor losses and a method for cash-flow generation by collecting option premiums. However, while covered calls can secure cash flow and mitigate volatility, they cap the gains on the written portion of the portfolio if the stock price surges beyond the call’s strike price. Nevertheless, the advantages of covered calls have led to growing interest among investors, particularly in the form of covered call ETFs.

Covered call ETFs are a simpler way to implement covered calls and have garnered attention for their ease of use without sacrificing the advantages of the covered call strategy, namely cash flow and reduced portfolio risk. In fact, they can be an attractive alternative to investors, who may implement this strategy themselves due to an ETF’s efficient trading, professional management and low management expense ratios. For many investors, covered calls are challenging to implement and manage, and these ETFs provide convenience by handling the call-writing process for investors.

BMO's: Largest Provider Of Covered Call ETFs

BMO is recognized as Canada's largest provider of covered call ETFs, with a diverse range of funds that cover various strategies, regions, countries and sectors. Since launching its first covered call ETF in 2011, BMO has focused on enhancing income and managing risk throughout market cycles. The ETFs, such as the BMO Canadian High Dividend Covered Call ETF ZWC and the BMO Covered Call Technology ETF ZWT, are designed to strike a balance between cash flow generation and participation in market upswings by writing call options on roughly half of the portfolio holdings and using a dynamic option writing strategy.

What is important for investors to understand, with an influx of new products coming to market, is that not all covered call ETFs are created equal. Seemingly small differences in methodology can make big differences to the bottom line. Understanding the methodology the ETF provider uses to generate the additional cash flow is important as this can help or hinder finding the right balance between the cash flow desired and the long-term growth needed. How much of the portfolio is written on, whether the options are at-the-money vs out-of-the-money, and the term on the options will all have an impact on how the strategy performs.  

Benefits Of Choosing BMO Covered Call ETFs

Investors in BMO's covered call ETFs enjoy several advantages:

• Higher Yield: The premiums from sold call options provide an added yield, enhancing the overall return from investments.
• Risk Reduction: Covered call strategies inherently reduce risk by providing income that can offset potential losses in the underlying stock positions.
• Tax Efficiency: Premiums earned from call options are usually taxed as capital gains, making this an attractive option for tax-sensitive investors.
• Lower Volatility: Historically, covered call strategies have been shown to offer similar exposure to underlying assets but with reduced volatility.
• Experienced Management: The BMO ETF team brings extensive experience in portfolio management and derivatives trading.

All that being said, while covered call ETFs present many benefits, the trade-offs should be examined. The primary concern raised is the trade-off between cash flow and growth, the potential to miss significant gains if the stock’s price exceeds the strike price of the call option. Investors should also understand the complexities of options trading and the specific strategies used in the ETFs they invest in. Choosing an ETF provider that provides full transparency into their strategy, including factors like how much of the portfolio they are writing on, whether the options are at-the-money or out-of-money, and the term to maturity on the options can help you determine how much upside you may be giving up in return for that enhanced level of cash flow.  

Canadians Take Note

Covered call ETFs represent a strategic option for Canadian investors seeking to enhance their cash flow and manage investment risks in a challenging economic environment. BMO's suite of covered call ETFs offers a professional, diversified approach to employing this strategy, making it accessible to a broad range of investors. For those considering this investment, a thoughtful review of the fund's prospectus and consultation with financial advisors is recommended to fully understand the potential rewards and trade-offs. To learn more, click here.

Featured photo by Hunters Race on Unsplash.

This post contains sponsored content. This content is for informational purposes only and is not intended to be investing advice.

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated. For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF's prospectus. BMO ETFs 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 ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

 This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual's investment objectives and professional advice should be obtained with respect to any circumstance. "BMO (M-bar roundel symbol)" is a registered trademark of Bank of Montreal, used under licence.