Market dynamics in 2022 and now into 2023 have reignited investor interest in yield-producing investments. Equity volatility, rising interest rates, and the return of an attractive bond landscape have resulted in investors seeking yields that outpace inflation, those offered by near-cash instruments, as well as by traditional guaranteed investment certificates.
While there is some upside to be found in the fixed income marketplace in 2023, even if an investor is yield-focused, their portfolio likely should not be disproportionately overweight to the bond arena, as credit risk, the potential for further rate hikes, and, ultimately, a lower return profile could hamper opportunity.
So, what’s the alternative for the yield-hungry investor? One strategy to consider is covered call ETFs.
Covered Call ETFs offer “portable yield” – a yield that is well-positioned as an alternative to fixed income. We refer to it as “portable” because while you’re still getting the underlying exposure to an equity benchmark, you’re effectively “porting in” yield through the applied covered call strategy. In other words, for investors with a positive outlook for equities or equity sectors, covered call ETFs can be used as a source of high monthly income generated from the equity portfolio itself, versus having to change the overall risk/return profile of fixed income holdings.
First, a quick reminder of how covered calls work: particular options, known as “calls,” are written on a stock or an index and sold for a premium providing additional yield on the investment. There are some trade-offs, like potentially less upside in powerful bull markets, but ultimately, covered calls can provide investors with a way to potentially generate yields from equity securities that don’t typically offer it.
Another benefit offered by covered calls is that the premiums generated are usually treated as capital gains, which generally have more favourable tax advantages when compared to income distributions. So as long as the overall view is for upside capital gains, they can create accretive income generation for a portfolio.
Investors can use the portable yield of covered calls to help enhance the yield of their overall portfolio without undermining their fixed income allocation, which can be important for providing a level of stability and defense in the face of choppy markets.
Covered Call ETFs have historically benefited from higher volatility, at least on a relative return basis, since the income they can earn would be expected to be higher during periods of higher-than-normal volatility. “Choppy markets” continue to be a reality right now: while the Volatility Index (VIX) – a popular measure of the stock market’s expectation of volatility – has withdrawn from recent highs in October 2022, it remains elevated, with the 2023 average index level of 19.87 higher by 543 basis points than the average level between 2010 through to 2020¹.
Take a look at the chart below, which shows the historical volatility versus the implied volatility of options writing on the NASDAQ-100® and the S&P 500® indices. In both cases, there is an attractive compensation offered to write calls relative to historical premiums.
Looking at the NASDAQ-100® specifically, we can see that higher volatility led to higher implied at-the-money option premiums for the NASDAQ-100® Index in the chart below.
One of the beneficiaries of these conditions is the Horizons NASDAQ-100 Covered Call ETF (QQCC), which has an estimated annualized yield of 13.19% as at January 31, 2023. Compare that to the current dividend yield for the NASDAQ-100®, which is 1.33%².
With the VIX still historically elevated, even with the early 2023 rally in “risk-on” assets, current market dynamics could be seen as a “win-win” scenario for covered call writers looking to generate excess income and positive returns.
These conditions aren’t all that new – in fact, they’ve been the case for the past few years. As you can see in the chart below, during 2021 and 2022, given the major equity market corrections and volatility spikes, covered calls appeared to have been a potentially better way to “own” equities.
Historically and for the most part, that has not been the case. While the covered call strategy can potentially offer better outcomes by generating higher premiums in volatile conditions, it will typically underperform in stronger bull markets relative to traditional long strategies.
Our view is that covered calls are best used as a yield-focused strategy and not as a market-timing strategy. For investors who are looking to generate yields to meet their income needs, covered call ETFs can be an effective way to earn some meaningful upside price return potential from equities. More importantly, they can be used to help generate high yields that are less correlated to interest rates than fixed incomes. The primary driver of income for covered calls is volatility rather than interest rates. As long as an investor is comfortable with the risk and return profile of equities, covered calls can generate yields that are much higher than most fixed income.
Below is a list of our equity-covered call ETF solutions and their associated yields as at January 31, 2023. The current average annual Consumer Price Index (CPI) inflation rate in Canada is 6.8%. Each of the ETFs below has yielded well above that threshold.
|12-Month Trailing Yield** (%)|
|Horizons Equal Weight Canadian Bank Covered Call ETF||BKCC||7.49%||7.62%|
|Horizons Canadian Oil and Gas Equity Covered Call ETF||ENCC||13.25%||12.78%|
|Horizons Gold Producer Equity Covered Call ETF||GLCC||9.81%||9.60%|
|Horizons Gold Yield ETF||HGY||6.03%||6.15%|
|Horizons Canadian Large Cap Equity Covered Call ETF||CNCC||9.31%||9.49%|
|Horizons NASDAQ-100 Covered Call ETF||QQCC||13.19%||10.90%|
|Horizons US Large Cap Equity Covered Call ETF (USD)||USCC.U||11.40%||10.54%|
|Horizons US Large Cap Equity Covered Call ETF||USCC||11.47%||10.43%|
Source: Morningstar Direct, Horizons ETFs Management (Canada) Inc. as at January 31, 2023.
*An estimate of the annualized yield an investor would receive if the most recent distribution rate stayed the same for the next twelve months, stated as a percentage of the net asset value per unit on the date before the ex-dividend date of the current distribution.
**The yield an investor would have received if they had held the ETF over the last twelve months stated as a percentage of the net asset value per unit on the last business day of the most recent month-end.
In each case, the amount of writing on these portfolios is generally up to approximately 50% of the portfolio, which means that the high levels of yield are effectively being generated from about half the portfolio with the other half providing a decent amount of upside exposure to the price return of the underlying equity asset class.
¹Source: MacroTrends.net, as at February 9, 2023. The average closing price between January 1, 2010, to December 31, 2019, was 14.438.
²Source: Macrotrends.net, as at February 8, 2023. The current TTM dividend payout for Nasdaq (NDAQ) as of February 8, 2023, is $0.80. The current dividend yield for Nasdaq as of February 8, 2023, is 1.33%.
Are Covered Calls right for you?
Generating income from equities
If you’re an investor who is comfortable with taking on some equity risk in your portfolio – you hold the view that stocks will increase in value over the next one to three years – then covered calls can be a source of income
Potential inflation-beating yields
The amount of income currently being generated is typically above the inflation rate thus, these can potentially be used to meet increasingly difficult income targets in an inflationary environment
Generally, the income generated from covered call ETFs is a mixture of tax-efficient capital gains, dividends, and in some cases, return of capital, all of which are generally taxed more favorably than investment income
Commissions, management fees and expenses all may be associated with an investment in exchange traded products (the “Horizons Exchange Traded Products”) managed by Horizons ETFs Management (Canada) Inc. The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the Horizons Exchange Traded Products. Please read the relevant prospectus before investing.
The investment objectives of the Horizons Canadian Large Cap Equity Covered Call ETF (“CNCC”) (formerly Horizons Enhanced Income Equity ETF (“HEX”)), Horizons Canadian Oil and Gas Equity Covered Call ETF (“ENCC”) (formerly Horizons Enhanced Income Energy ETF (“HEE”)), Horizons Equal Weight Canadian Bank Covered Call ETF (“BKCC”) (formerly Horizons Enhanced Income Financials ETF (“HEF”)), Horizons US Large Cap Equity Covered Call ETF (“USCC.U, USCC”) (formerly Horizons Enhanced Income US Equity (USD) ETF (“HEA.U, HEA”)), Horizons NASDAQ-100 Covered Call ETF (“QQCC”) (formerly Horizons Enhanced Income International Equity ETF (“HEJ”)), and the Horizons Gold Producer Equity Covered Call ETF (“GLCC”) (formerly Horizons Enhanced Income Gold Producers ETF (“HEP”)), were changed following receipt of the required unitholder and regulatory approvals. The ETFs’ new tickers began trading on the TSX on June 27, 2022. For more information, please refer to the disclosure documents of the ETFs on www.HorizonsETFs.com.
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