Will covered call ETFs cover you in a bear market?

There is no pun intended here, but that's what covered call ETFs are meant to do: get you at least partly covered if the market slows down or tanks. The recent runup in equity prices has rendered dividend yields far less attractive, such that investing for income has become a major challenge. Moreover, with every new high that the market reaches, the case for being better prepared becomes more compelling. So the idea is to look for investments that keep you exposed to equities, so that you can benefit from further upside, if there is still any, while keeping your losses at least parlty contained when the music stops. And if such investment can spit 4% to 5% per annum in monthly cash payments, then so much the better.

If this sounds like a proposition for conservative, income oriented investors only, it is exactly that. For what we are describing here would best work if the market gets stuck in a range or starts posting only modest gains beyond this point. This is not good in a raging bull market environment. Nor is it a magic solution if there is a deep market slump: when that happens, lose you will. But chances are your losses will be at least partly contained versus a straight investment in an index fund or ETF.

The covereed calls strategy covered in this note aims to hit three birds with the same stone: first, it keeps you invested in equities such that you do not totally miss out on the next round of appreciation, if or when it happens. Second, it boosts your monthly cash distributions by anywhere between 50% to 100% more than what you would otherwise get from a regular equity portfolio. And third, it is designed to reduce your losses in a downmarket scenario.

A covered call strategy consists of buying shares of targeted companies and writing (i.e. selling) call options on those same shares. However, this is not something we would suggest you do on your own. If you like any of the ETFs featured in the attached table, you can ask your advisor to consider it for you. We are highlighting the main features of each ETF, its advantages and risks and under what circumstances we think it would work the best. By the way, the featured ETFs have advisor series, i.e. they can also be bought through advisors.

To refresh your memory, we will use a random example to highlight how the featured ETFs operate. Suppose you buy 100 shares of the RBC Group at $100 each (The price might be higher or lower when you read this, but we are using a round number to keep things simple). You simultaneously sell 100 call options, at the strike price of $105, for a premium of $4 (i.e. $400 in total), expiring in one year (again we are using random numbers here for the sake of illustration). In other words, you are committing to sell your RBC shares at $105 regardless of the prevailing market price, anytime during the year, if you are asked by the option buyer to do so. Obviously, the option holder will exercise it only if the share price rises above $105 during that year, otherwise the option will have no value and will expire unutilized.

One of three things can happen during this one-year period:

Scenario 1: the share price keeps trading within a close range around $100 but below $105. This means the option expires and you get to keep your $400. You also collect $390 in dividends each year. Thus your total cash income for that year will be $790, or 7.9% p.a. (versus 3.9% p.a. if you just bought the shares). You also get to keep your investment in the shares. When the options expire, you just repeat the same transaction and cash the premiums and the dividends for another year. This is the ideal scenario for this strategy, but unfortunately, it does not always work like that.

Scenario 2: The share price climbs above $105. Here, you will be obligated to sell your shares at $105 even if the price reaches the sky. Your total gain from the investment will be $9 ($5 in capital gain plus $4 in premiums collected for the option). So your return on the investment will be some 9%. And, depending on when the option is exercised, you might collect dividends on the investment for a quarter or more.

Option 3: RBC share prices tank, say to $90. In this case, your losses are reduced by $400, being the premium you collected for the option.

The main disadvantage of the strategy is that, if the share prices soar far beyond $105, your gains will be limited to 9%. So your fund will under-perform the index significantly. This is why this strategy works the best if the market stages modest appreciation, or if it gets stuck in a range. Remember that you are selling options here, and when you do that, volatility is your enemy.

Which brings us to the next point or the second disadvantage: the strategy will perform poorly when we see wide, up and down fluctuations. Here is a possible lousy scenario, which we will call scenario 4: after you bought RBC shares and sold the options, the price drops to $80. So you've lost $16 or 16% ($20 in share price depreciation, less $4 in option premiums). What do you do next? Suppose that, faithful to the strategy, you sell new options for a strike price of say $85 or $90. If RBC starts going up again and recovers its losses, you will not take full advantage of the rebound because you will be forced to sell at$85 or $90 shares that you initially bought at $100!

The purpose of bringing Scenario 4 to your attention is to highlight the risks of the strategy and to show why it does not work well under conditions of high volatility. More importantly, it is to show why you should only do it through a specialized hedge fund or ETF. A successful covered calls strategy requires astute decisions such as: when do you sell the options, for what strike price and for what period. We think this can only be done through qualified money managers.

If you click here, you will get access to a detailed analysis of six ETFs currently offered by BMO which are traded on the Canadian stock exchange. The link includes a brief analysis of each ETF plus a comparative table depicting several metrics of each ETF versus that of a similar portfolio without covered calls. So you get to compare the overall performance of the covered call ETFs, their cash distributions advantage, and their performance during the recent 2018 correction, versus that of an equivalent simple index portfolio investing in the same stocks.

October 6, 2018