Covered Call ETFs Provide Good Income, but There’s a Catch

As interest rates have fallen, alternative income-generating assets have become quite popular. Many retirees and other folks living on interest just can’t make it work earning 2% a year from a GIC.

Covered Call ETFs have become a semi-popular alternative. These ETFs use call options to generate additional income from dividend stocks. When the strategy works correctly yields are boosted while still retaining ownership of the underlying stocks.

Most retail investors don’t have the experience to pull off such a move, so they turn to ETFs as a passive way to get exposure and collect attractive dividends.

BMO Asset Management dominates the covered call ETF market in Canada. The BMO Covered Call Canadian Banks ETF (TSX:ZWB) has $1.3 billion in assets and pays a 5% yield. The BMO Covered Call Utilities ETF (TSX:ZWU) has nearly $1.1 billion in assets and pays a 6.75% yield. Both these ETFs have a management expense ratio of 0.72%.

While these ETFs are a decent deal for income seekers, they don’t stack up well in volatile stock markets. When stocks head higher, the underlying call option gets exercised. These ETFs don’t want that to happen because it limits their upside.

Say a covered call ETF generated $1 in income selling a $70 call on a stock trading for $68. The stock then moves up to $75. The ETF would be forced to sell at $70, missing much of the upside. Thus, these ETFs struggle in strong markets.

An investor might get more income from a Covered Call ETF, but when stocks are going up it’s better to just own a sector ETF. That will lead to greater total return.