Tag covered call

Covered Call & Leveraged ETFs

Paul - The Wry Eye Guy Leave a comment
The Ballast & Boost of Covered Calls & Leverage!

It’s generally accepted that it’s tough to beat the performance of low-cost, index-tracking ETFs. After fees, most actively managed professional funds don’t beat the indices over the long haul. While we can get lucky from time to time, most DIY investors can’t beat the indices either. We can however, have our heads turned by an attractive income stream. High yield ETFs have found new life since the covid lockdown. The whole work from home thing had many of us wanting to carry on working from home forever. If we could figure out how to get our investment portfolios paying as much as our day job, we could call it quits & be totally done with working for a living, eh?

Traditionally, you could build an income stream with a portfolio of dividend stocks or with some dividend yielding ETFs. Covered call writing can boost the distribution of an ETF beyond the dividends of the holdings. For investors who need an income stream, it’s an attractive proposition. You get a bigger income stream, without the hassle of selling shares for income. And you might not have to worry about selling shares in a down market. The negative thing about it is that you often lop off some of the upside with a covered call strategy. Selling a call means that you’ve made a few extra bucks, but you now have a contract to sell your shares at an agreed price. If the stock goes beyond that strike price, your shares are called away & the option buyer gets to buy them at a lower price than they are then worth. You’ve lost some of the upside. In general, these covered call ETFs will underperform an ETF that just holds the same stocks for growth. But so long as the underlying value of the covered call portfolio continues to grow, some people are okay with that. Instead of paying a financial advisor to give you a monthly cheque, you’re just letting the ETF manager use some of the upside to pay for the service. Some think that a covered call ETF will protect them when the market drops. That’s often not true. Other than the extra option premium we get, these ETFs can crash every bit as far & as fast as a regular ETF holding the same stocks. In general, covered call ETFs are more likely to underperform over the long haul. Though some are better than others, so you do need to compare before taking the plunge.

Fund managers are good business people. They know a good opportunity when they see it. They watched the enthusiasm for covered call ETFs growing & they realised that they could make it more appealing with the even bigger income stream that is available through the use of leverage. Leverage is borrowing money to invest in more shares. While borrowing cash for stocks can be an intimidating proposition for an individual, it’s a lot easier if the fund manager does all that for you inside the ETF. You can now find many ETFs advertising the enhanced yield that comes from using modest leverage. Those are marketing words with a lot of allure. Who doesn’t want “enhanced” yield? And nobody should fear “modest” leverage, right? You can see the appeal of the marketing message, eh?

But how well does this combined approach work?

The covered call bit is pretty straightforward, but let’s look at the effects of leverage. Since many of the new funds are too new to have any worthwhile history to examine, let’s start with a Canadian index fund instead. Canadians love Blackrock’s iShares S&P/TSX 60 Index ETF, XIU. If you invested $10k in XIU back at the start of January 2000, with all dividends reinvested, you’d be sitting of a portfolio worth $47,757.00 today. If Grandma had loaned you enough money, at a zero percent interest rate, to apply a 25% leverage ratio to your investment, you would have $65,269.00 today.
Oh yeah, baby! Gotta love that leverage thing, eh!

Now what if Grandma had offered to loan you the leverage money at a 7.2% interest rate? Would you have taken her up on it?

If you had, your portfolio would be worth only $42,487.00 today. That’s a lower return than just investing in XIU without leverage. I think Grandma suckered you! I cheated a bit here to make a point. That 7.2% is the current prime lending rate. Interest rates were lower for much of that time & you’d have fared better with lower cost leverage. But if you were to get your own leverage by applying margin within your brokerage account, you might pay even more today. Check the margin rates at your brokerage. Fund & ETF managers can get better rates than we can, of course, but their fund returns will be negatively impacted by higher interest rates too. It all adds to the costs involved with managing these funds. These numbers won’t be on the front page of the ETF brochure. You’ll often have to dig into the multi-page downloadable documents (prospectus & financial statements) to see what these costs are. You’ll also find the TER (Trading Expense Ratio) here. I know, I know, I hate that small print stuff too. But once you dig, & with today’s higher rates, it’s not difficult to find a fund like this with a real total expense ratio of 2% or more. Let’s be real, the size of the fee doesn’t matter if the performance is good enough to pay for it. But if it’s not, we might do better with an advisor charging 1% to put us into low cost index funds & letting them do all the work to make sure we have an income stream every month. I’ve taken some liberties with this simple example here, but what’s the takeaway?

Going into one of these ETFs can be a bit like putting a donkey into a horse race. Generally, the low-cost index funds are the race horses. Active management adds more cost & doesn’t always add more return. Adding a covered call strategy is like putting bricks on the back of the donkey. They slow our ass down! Adding leverage is like using helium balloons to compensate for the drag of the load of bricks. How well a fund manager balances the bricks & the balloons over time will determine the fate of the investment. As will the fees charged for doing all that work. Interest rates have an impact too. The value of leverage goes down when interest rates go up. And leverage increases volatility. When the underlying investment goes up, leverage will make it go up further. When it goes down, leverage makes it go down further. The investor’s ability to handle that volatility is important too. It’s no surprise that leverage works best with assets that show consistent growth in a low interest rate environment. Check the history of total return when comparing one of these high yielding ETFs against a simple equity ETF. New funds lack history & it’s nice to see if a fund has proven itself over time. And during different market conditions. While past performance does not predict future results, it’s always worth taking a look at past performance before you place a bet with your retirement money.

Doing this comparison is even more critical if all the distributions are being pulled out for living expenses. A fund that consistently declines in asset value, as distributions are removed, is far more likely to provide a declining income stream over time. Try out the tools at Portfolio Visualizer for these comparisons. It gives a great snapshot of performance differences between funds. And it can show the history of the income stream. A declining income stream over time might not work well for an early retiree with a long time horizon.

While index investing is often recommended for investors with a long time horizon, there is an undeniable attraction to a nice income stream at any age & stage of the investing journey. But, starting out, be a little careful about how much of your portfolio is allocated to high-yield funds. Having great underlying holdings isn’t always enough. That does not mean that these funds don’t have a place in some portfolios. Just be careful with your choices!

There is another post on Canadian Banks for Dividend or Covered Call Income? if you want to read more on a comparison of the covered call approach.

If you want to learn more about all this from the ground up, I’d like to suggest that you check out Double Double Your Money, available at your local Amazon store.

Important – this is not investing, tax or legal advice, it is for entertainment & educational purposes only. Opinions are my own, so do your own due diligence & seek professional advice before investing your money.

Canadian Banks for Dividend or Covered Call Income?

Paul - The Wry Eye Guy 1 Comment
Dollars & Dividends

We love our dividends in Canada. If dividends are so great, why not go for the even greater yields available with covered call ETFs? Maybe we can toss all our investments into covered call ETFs & retire early? That sounds great!
But does it work?

Maybe!

Every investing strategy has its fan base. But at the end of the day, it all comes down to how the numbers work for the individual investor. And covered call ETFs can work for some investors.

However, some features of covered call writing can be less appealing. The notion of covered call ETFs having lower volatility, for example, may be true. But volatility is a measure of an investment going up, as well as down. In general, covered calls will limit upside. If a growing stock is called away, you lose some of the upside. As investors, we don’t mind volatility if it means our investment is going up. We only fret when it goes down. Hand in hand with that is the idea that covered call writing offers some downside protection. You’ll notice the wording in the description of many funds says something like downside protection may be limited to the returns provided by the covered call premium. That’s marketing speak for “we can crash as hard as anything else but you’re at least getting that juicy covered call premium along the way”. Unfortunately, during times of growth or recovery, the capped upside often means that the growth of a covered call fund doesn’t match that of a fund holding the equities directly.

Let’s take a look at an example using only Canada’s big banks. The five largest banks in Canada all started paying dividends in the 1800s. That’s a little too far back to look at, but if you’d invested $100k in an equal-weight holding of the Big 6 banks back in January 2000, that portfolio would have grown to almost one & a half million dollars today! Investing in the large cap American or Canadian market index funds would only have returned under half a million over that time. Of course, nobody would risk going all in on just the Canadian banks. Right!?! But this kind of performance is why Canadians like their banks.

To compare the different investing strategies, I’ll use BMO’s ZEB & ZWB here. Both ETFs are designed to track the Solactive Equal Weight Canada Banks Index. And both funds are managed by BMO Global Asset Management, one of Canada’s largest ETF providers. ZEB just holds the banks. ZWB holds the same banks, but adds a covered call strategy to about 50% of the portfolio to generate a bigger income stream. These ETFs have a relatively short shared history, so we’re only looking at returns over an 11.5 year period up to the middle of this year here.

Accumulation
During the accumulation years, all dividends & distributions are reinvested, that’s the “DRIP ON” scenario in the table below. This shows the Total Return, with dividends reinvested, from a $100k investment directly in the bank stocks. And it compares that to the same $100k investment in ZEB & ZWB.

It’s probably no surprise that directly investing in the stocks produced the greatest return. The direct investment was rebalanced semi-annually, to match the index tracking guidelines used by the ETFs. While ZEB does all that work for us, the fees charged by the fund cause a little drag on the returns. Since covered call writing lops off some of the upside potential, it’s also not a surprise to see ZWB trailing the pack here. It’s CAGR & Best Year are poorer. But, it’s worth noting that it’s Worst Year is slightly worse than the other two. Fund managers do warn that covered call funds “may” provide downside protection. Sometimes, that might only be by the amount of the covered call premium. But it’s not a guarantee. Since ZWB had the biggest drop of the three, the covered call strategy didn’t provide much of a safety net during the covid crash of March 2020. It’s possible that longer periods of sideways, or slightly down, markets could have allowed ZWB to produce a better relative performance. All in all though, it’s a pretty good performance for all strategies. That’s the accumulation picture. Next we’ll look at what happens when we start spending the income.

Spending the Money
Things change when we retire & need to spend some of our savings every year. All sorts of new challenges come up. The ideal scenario for many retirees is to have their investments generate enough dividends & distributions for them to live on. No worries about having to sell shares in a down market, & so on. Here’s how these three investments deliver on the income front.

This table shows the picture for an investor who retired in 2012 & sucked out all the dividends & distributions for living expenses along the way. The holder of ZWB would have had more income over the 11.5 year period. Though overall, perhaps not the best value, since the value of the underlying portfolio didn’t grow as much as the other two. If an emergency situation forced the sale of some shares to raise capital, the other two approaches had far bigger portfolio values to draw from. Aside from the income, the positive thing about all these results is that the underlying assets continued to appreciate. All these ETFs show positive CAGR. And this is with all the dividends & distributions taken out. BMO’s limited covered call strategy, over this timeline, worked well. Any income investment that shows negative CAGR for the underlying assets (with DRIP off) might be an exposure for a retiree with a longer time horizon. The portfolio value would decline over time & that will have an impact on the income stream over the long haul too. There is one other exposure here & that is the impact of inflation. If we adjust the End Value of the portfolios in the above table, the Big 6 & ZEB are worth an inflation-adjusted amount of about $150k. The End Value of ZWH, in 2012 dollars, is just under $95k at the end. This isn’t quite accurate, as the inflation adjustment comes from US inflation data, not Canadian. But it still shows the importance of having a portfolio capable of staying ahead of inflation.

Here’s what the income streams look like for these investments …

While ZWB starts out with a far greater annual income than the other two options, it shows more variability than the other two. Variability of income from year to year can be an issue for some retirees. Perhaps more importantly, the other income streams are catching up as time goes by. Direct investing shows a more consistent upward trajectory, even without any additional investment or DRIP. And this is exactly what you’d hope for with a portfolio of dividend-growth stocks. The dividend growth is what grows the income stream. That can be very important for an investor with a longer expected time horizon in retirement. Early retirees should watch out for this.

The Canadian banks generally do well over time. For portfolio growth & for growth of income. But now it’s down to personal choice. Do you prefer to trade some long-term portfolio value for the bigger income stream of the covered call approach early in retirement? Or do you like the more consistent growth of the income stream that comes from a portfolio biased towards dividend growth? There are a lot of factors that go into individual decisions. For a young investor with a long time horizon, total return is probably going to be more important than the size of the income stream starting out. It might also be more important for an early retiree. Or for a healthy retiree with a longer life expectancy. Things like leaving an inheritance, planning for home care or a retirement home, & so on, all factor into the decision making process too. Regardless, the Canadian banks have been a pretty solid investment over time & they look good in all these scenarios. Of course, as you’ll find noted on every fund’s webpage … past performance is not indicative of future results! We can’t just assume an investment will continue to do well in the future because it’s done well in the past. The banks have been great performers historically. But not all stocks or funds perform as well as the banks did here. Be sure to compare your choices for total return & income growth. And not just the size of the yield!

If you want to learn more about all this from the ground up, I’d like to suggest that you check out Double Double Your Money, available at your local Amazon store.

Important – this is not investing, tax or legal advice, it is for entertainment & educational purposes only. Opinions are my own, so do your own due diligence & seek professional advice before investing your money.