Unmasking Covered Call ETFs' Allure

Covered call ETFs have emerged as a hot topic among investors due to their promise of hefty monthly payouts. However, experts warn that potential buyers should proceed with caution before getting swept up in the allure.

What Is a Covered Call ETF?

Essentially, a covered call ETF is an exchange-traded fund that maintains a portfolio of stocks while generating income by selling call options on those holdings. They are often marketed as an easy way to earn income and reduce volatility, giving investors exposure to complex strategies without the legwork.

The Trap of High Yields

Yet, many investors may fall for the high yield advertisements and overlook significant long-term drawbacks. Financial planner Anita Bruinsma from Clarity Personal Finance highlights a crucial point: while covered call ETFs do provide regular payouts, a substantial portion of that income isn’t derived from actual earnings.

"Much of it is simply returning your own money," Bruinsma explains, referring to the concept known as return of capital. Investors who aren’t aware of this might mistakenly believe they are earning genuine income from the fund.

Examining the Numbers: A Closer Look at HBIE

Take the Harvest Balanced Income and Growth ETF (HBIE), for instance. Bruinsma notes that the fund boasts a striking distribution yield of 10.37%. Yet, when digging deeper, you’ll discover that in 2024, investors received $1.80 per unit, of which only a mere 6.07% was actual Canadian dividend income.

The kicker? A whopping 52% of the payout was merely a return of capital, which can lower the adjusted cost basis of your investment. This means, when you finally sell your units, you could face significant tax implications due to capital gains.

The Real Income Yield: A Shocking Reveal

While investors might think they’re raking in 10%, the genuine income yield is much closer to 4.8%. Bruinsma points out the disparity: "The marketing sounds fantastic, but there’s always more beneath the surface."

The Opportunity Cost of Covered Call Strategies

Aravind Sithamparapilla from Ironwood Wealth Management emphasizes the opportunity cost associated with covered call strategies. While these funds can theoretically perform well in stagnant or bearish markets due to the extra income from options, they often miss significant gains when the market takes off.

Let’s illustrate this with the BMO Covered Call Canadian Banks Fund (ZWB.TO) versus the BMO Equal Weight Banks ETF (ZEB.TO). Launched in 2011, ZWB.TO has returned 211.2% as of June 20, but the non-covered call version, ZEB.TO, has outpaced it massively with a colossal 339.7% return across the same timeframe.

Sithamparapilla summarizes, "Over the past 14 years, you would have garnered more than three times your investment with the standard ETF compared to only double with the covered call version."

Navigating the ETF Minefield

Before jumping into the covered call ETF frenzy, investors must arm themselves with knowledge. Despite the enticing high yields, understanding the underlying mechanisms and potential pitfalls is crucial for making informed financial decisions. So, tread wisely!