Controlling Beta Risk in ETF Portfolios Part 2
I often get asked about when to use covered call ETFs versus similar exposure that does not have the enhanced yield. The general answer is that in sideways to falling markets, a covered call strategy will generally improve your results. For Canadians, the benefit of the dividend tax credit is only relevant for Canadian corporations or ETFs where the origin of the dividend is a Canadian corporation. For our example today, we are going to look at the equal weight Canadian Bank ETFs from Bank of Montreal. Since inception Feb 28, 2001, the annualized total return for ZEB (BMO Equal Weight Banks) is 9.5% and for ZWB (BMO Equal Weight Banks Covered Call) is 8.02%. The difference in MER is 10 bps (0.62% vs. 0.72%). The ZEB has outperformed by 1.28 bps annually. BMO’s style of covered call writing is to write options about 2% above current prices on about half the portfolio each month. All ETF option strategies have a slightly different style. And it matters how much of the portfolio they write and what degree out of the money they write them. These are key factor in determining how much extra yield you get. The level of overall market volatility is important too. The higher the VIX (volatility) the higher option premium tends to be. The beta of ZWB is about 72% compared to the TSX composite and ZEB is about 79% or about 90% of the volatility.
But during periods of weakness or sideways markets, we see the following differences:
|Apr 11 to Nov 11||-13.42||-12.04|
|Sep 14 to Feb 16||-18.55||-15.90|
|Jan 18 to Oct 18||-5.32||-4.42|
So you can see during down market periods, the extra yield from the options strategy tends to do better. But during the strong periods, the options strategy tends to eat into your upside. If the stocks get called away, they need to be bought at higher prices, which can limit the capital gains potential. It really depends on the speed of the market advance, which we cannot know ahead of time.
|Nov 11 to Sep 14||80.34||65.7|
|Feb 16 to Jan 18||60.42||48.41|
As you can see, in general up markets, there is dramatic outperformance. The general idea than is that when you are generally bearish, you will do better with the covered call strategies and when you are generally bullish, do not own the option strategies. If you want to be tactical, look to own ZEB during periods where we see a market bottom and use ZWB when upside potential for stocks overall are limited. A tactical strategy can further increase your long-term experience. As always, you need to consider that in taxable accounts, all the trading will generate annual capital gains taxes. Ideally, these strategies work best in registered accounts where tax treatment is always the same. It’s income when you ultimately withdraw the funds from your account.
Our fall roadshow is coming to a close, we have only 3 more events this season. Come out and find out how to profit while protecting in the longest bull market of all-time, where I will look at some of my top sector ETF picks for the next few years and teach you how to build balanced portfolios using less risky options strategies that will work better in the next few years. Click here to register for free and as always we ask for volunteer donations to one of our two favourite charities. Children’s cancer research at the Sick Kids Hospital and Alzheimer’s and dementia research at the Baycrest Hospital.