Horizons AlphaPro recently launched four covered-call ETFs. They are: Enhanced Income Equity ETF (HEX), Enhanced Income Financials ETF (HEF), Enhanced Income Energy ETF (HEE) and Enhanced Income Gold Producers ETF (HEP). Each of these ETFs (prospectus is available here) offers investors exposure to a portfolio of stocks and generates income by generally writing at or slightly out of the money covered call options on 100% of the portfolio securities. The stocks held by these ETFs are slightly different. HEX holds an equally weighted portfolio of 30 of the largest and most liquid Canadian stocks listed on the TSX. As the name suggests, HEF holds a portfolio of equally weighted financial services stocks. Note that HEF holds a more diversified portfolio and employs a slightly different strategy than the BMO Covered Call Canadian Banks ETF (ZWB). HEE and HEP hold an equally-weighted portfolio of energy stocks and gold stocks respectively.
All of the Horizons AlphaPro Covered Call ETFs charge a management fee of 0.65% plus HST. HEX, HEF and HEE will make monthly distributions that will be mixture of dividends and call option income, which will be treated as capital gains. Since most of the stocks held by HEP do not pay a dividend, pretty most of its distributions will be options premiums. It is important to note that monthly distributions are not fixed.
According to Eden Rahim, portfolio manager for the AlphaPro Covered Call ETFs, short-dated covered calls are written with a dynamic strike price based on the volatility. The probability of exercise is around 25%. Mr. Rahim says that writing call options on component stock is more profitable than writing options on an index ETF such as XIU. He estimates that HEX will distribute 7 percent or more options income in addition to the portfolio’s dividend yield of approx. 2.5%.
The key attraction of covered call ETFs is the ability to generate income from a portfolio of stocks. For example, in the first two months since inception, HEX has made two distributions at an annualized 20% rate. A second benefit, as noted in this earlier post, is the lower volatility exhibited by a portfolio with a covered call strategy.
On the negative column, it should be noted that covered call ETFs charge a much higher fee than long-only broad market index ETFs (0.65% versus 0.15 for XIU). Also, it should be noted that operating expenses of covered call ETFs will be higher compared to index ETFs due to higher turnover.
Investors should keep in mind that if call options are correctly priced, a covered call options strategy is neutral* and expected returns will be exactly the same as a long-only portfolio before fees and taxes. But as pointed out earlier, covered call ETFs cost more and the much higher turnover will reduce after-tax returns. Investors should carefully consider whether trading future capital gains for current distributions is a trade off they want to make. After all, in investing, it is total returns that ultimately matter, not just monthly distributions.
* – Hat tip to Raymond Kerzerho of PWL Capital for a discussion on this topic.
Other Resources: In a recent column, Rob Carrick urged investors to pay more attention to covered call ETFs than just their high distributions.
