PM predicts disappointment from covered call bond ETFs

While the excitement around the covered call ETF space is hardly surprising, particularly given the hefty return expectations generated by some of the latest product launches, investors would do well to take those offers with a hefty grain of salt.

“You look at these things from 30,000 feet and think you understand them,” says Colin White, a veteran portfolio manager who’s also president and CEO of Verecan Capital Management. “But there’s complexities out there that are going to make them dramatically different.”

Colin White was awarded in 5-Stars Advisors. See all the winners along Thomas Cook as the Best Financial Advisors in Eastern Canada here.

Options strategies: appealing, but poorly understood

As a portfolio management shop, White says Verecan doesn’t use covered call ETFs, preferring instead to implement covered call strategies within the group. While he agrees it makes sense to examine the strategies on the market, he says they would not necessarily be using the ETFs available right now.

The newest covered call bond ETFs funds hold a twofold appeal for investors: they are creating fairly high expectations of return – with income projections as high as 15% – while focusing on US government bonds, an asset class perceived as very secure by the investing public.

“We think the risks are not being accurately appreciated,” White says. “If there was a low-risk way to get 15%, that’s where all the money would go. If we just took it on its face as a real thing that everybody should be doing, the Ontario Teachers Pension would be doing it.”

For covered call strategies, White says, the exact nature of the underlying options contracts that get written is unclear, and there can be different types of failure that can play out with options strategies.

“If we look back at double-bear and double-bull ETFs, those products were misused. They were not designed to be buy-and-hold; they were designed to be held for maybe a day or two. But that wasn’t how they were universally used,” White says. “Nobody understands the backwardation and the contango on options contracts. Those contracts have attributes to them that can lead to maybe unanticipated outcomes.”

“What the strategy does is give away the upside, and you’re getting involved in asset classes like TLT, that’s been negative 15% or 16% per year for the last three years,” he says. “You’re going to use that as an underlying strata for something, and you’re going to make a deal to give away all or most of the upside going forward. That doesn’t seem to be the right play.”

A trade more than a trend

The investment thesis for covered call bond ETFs appears to hinge heavily on the manifestation of a higher-for-longer rate environment, but shifts the markets make it hard to say for sure.

Just in the past three months, White says markets were actually pricing in a downward trend in rates starting in autumn. Even the powers-that-be at central banks, he notes, are prone to change direction on a quarterly basis as they adopt a data-dependent approach to policy setting.

“Volatility is causing better premiums on the options contracts, and the fact that there has been more volatility has helped these new products see more profit right now,” he says. “But again, that volatility can go away. And if there’s any kind of a pause or decline in interest rates, these products are going to get really affected.”

Certainly, the pace of innovation in the Canadian investment fund space over the past few years has been something to see. But while it offers the potential benefit of more choice for Canada’s investors, White is seeing managers launch products based on what people demand, and not necessarily aligned with what’s right for them.

White commends the spirit of innovation and embracing opportunity that drives Canada’s investing space, but he argues that managers often would look at the short term rather than develop a strategy that’s more sustainable over the long term. As for the opportunity that the new covered call bond ETFs are tapping into, he sees that as a trade rather than a long-term trend.

“There’s more likelihood that people are going to get into [a covered call ETF] without really understanding it, and stay with it long beyond the efficacy of the situation it’s launched for,” White says.

“The market for shortcuts far exceeds the supply for shortcuts. Everyone’s looking for a quick way to get money. Unfortunately, that causes people to stretch,” he says. “If you’re going into these with double-digit expected rates of return, you’re more likely going to get disappointed.”