How investors can benefit from covered call ETFs

It is hard to argue with the value proposition offered by exchange traded funded (ETFs), and the growing awareness of investors is reflected in the continued growth of the sector.

Collectively, the more than 600 ETFs listed on Canadian exchanges saw net investment of $5.1 billion in the third quarter of 2018, a hefty gain over the previous best-selling third quarter of $3.4 billion in 2015. ETFs have attracted over half of all net investment in 2018.

“The high-level, key advantages of ETFs are transparency, liquidity and low cost,” says Chris Heakes, director and portfolio manager of BMO ETFs, which led quarterly sales among providers. “Especially in a world where interest rates are lower and returns on equity are forecast to not be as high, cost is meaningful for investors. We’re in an environment where these factors really matter: having low cost, effective and efficient solutions can move the needle.”

ETFs are also relatively easy for investors to understand, given that they are essentially mutual funds, for a long time the most popular form of investing for Canadians. Buying a portion of a basket of assets is a now-familiar concept, and because they trade on Canada’s stock exchanges, ETFs can be bought and sold throughout the day. ETF providers also tend to disclose their daily holdings to a greater degree than traditional mutual fund providers, so advisers and sophisticated investors can avoid overlap and align with asset allocation targets, says Heakes.

For those who are entirely new to ETFs, it can be helpful to know that ETF providers are governed by the same regulations as mutual fund providers. A Canadian innovation, the first ETF was launched on the Toronto Stock Exchange in 1990, designed to deliver the gains of the entire market to investors. Rather than attempting to predict which stocks would outperform, these early “index” ETFs track the whole market to minimize management and administrative costs while optimizing returns. These types of index ETFs still make up the bulk of investment in the sector, but have since been joined by hundreds of funds that cover almost any investment ideas investors desire to incorporate in their portfolios.

Those who haven’t jumped on the ETF bandwagon yet often suffer from a completely understandable misapprehension: the idea that paying more for management translates into better returns. “It’s something that certainly should be the case,” says Heakes. “Over shorter periods of time, certain managers will outperform; certain managers will underperform. But generally speaking over longer periods of time, five years plus, 95 per cent of active managers will underperform indexes. Investors have to be careful that they are getting value for those solutions that carry higher costs.”

In other words, it is impossible to predict in advance which managers will outperform, and to guess how long any outperformance might last. The overall result is reflected in an immense body of research that shows that reducing costs has more impact than trying to outperform the market. Identifying mispriced securities (value investing), counting on future profits (growth investing) or timing the market (momentum investing) all have their moments, which is why, more and more, providers are moving to offer a full range of investment approaches, all congruent with the low-cost value proposition of that first ETF.

As investors have embraced ETF investing, the sector has broadened its offerings, moving from basic index funds to different investing styles. At BMO, for example, is a unique mandate that offers investors participation in a “covered call” strategy, BMO Covered Call Canadian Banks ETF (ZWB). Ideal for more conservative investors who want to limit loss potential while still participating in the higher return potential of Canadian bank stocks, ZWB provides an additional level of income by selling a portion of the potential upside on its stock holdings in return for current income. A portion of potential income (should stocks con- tinue to rise) is sacrificed to minimize losses should values decline.

Another option proving popular with investors is BMO’s suite of low-volatility ETFs, Heakes notes. “They invest in stocks that tend to be more defensive than the broad market. This can be very beneficial to investors who are concerned about risk or have saved a nest egg they plan to live off of for many years. Investing in lower-volatility stocks can provide equity growth, reducing the risk level relative to the broad market should a major decline occur.”

On the fixed income side of the portfolio, ETFs offer an extremely convenient and efficient way to invest while minimizing costs that would otherwise have a significant impact given today’s lower returns. “That universe can be dissected between government bonds and corporate bonds and by the term of those bonds,” says Heakes. “ETF providers have also been very innovative in offering options that have been difficult for investors to access, such as high-yield bonds and emerging market bonds – even global infrastructure equity.”