Answering advisors' call for income

This article was produced in partnership with Horizons ETFs.

Horizons ETFs, one of Canada’s largest ETF providers, has recently relaunched its covered call ETF suite after making changes they believe will help enhance their ETFs’ ability to offer competitive yields and generate attractive income in today’s volatile marketplace.

With bonds underperforming and equity markets even more precarious lately, covered call ETFs can potentially offer investors some downside protection on their equity holdings by generating income through options writing.

To find out more about how these products could be the right option for investors today, Wealth Professional spoke to Nick Piquard, Vice President, Portfolio Manager, and Options Strategist with Horizons ETFs.

Nick co-manages the firm’s global suite of covered call ETFs, which essentially fall into three categories. Firstly, broad-market offerings – Horizons Nasdaq-100 Covered Call ETF (“QQCC”), the Horizons Canadian Large Cap Equity Covered Call ETF (“CNCC”), and the Horizons US Large Cap Equity Covered Call ETF (“USCC”) – which track the Nasdaq-100®, and the large-cap market segments of the  Canadian and U.S. equity markets, respectively.

The second group focuses on specific sectors – Canadian banks through Horizons Equal Weight Canadian Bank Covered Call ETF (“BKCC”), Canadian energy via Horizons Canadian Oil and Gas Equity Covered Call ETF (“ENCC”), and also gold producers through Horizons Gold Producer Equity Covered Call ETF (“GLCC”).

Horizons ETFs also offers a physical gold covered call ETF, the  Horizons Gold Yield ETF (“HGY”) – which writes calls on securities and other instruments that provide exposure to the price of gold bullion which Piquard believes is the only one of its kind in North America.

Although the firm has offered its covered calls ETF suite for a decade – one of the first firms in Canada to do so –  their recent changes to the underlying baskets of stocks as well as the new dynamic writing strategy for these ETFs were undertaken in an effort to maximize yield and to target more income-focused investors.

Why covered calls?

Piquard says that there are two main reasons why covered call products might be right for the current marketplace. “Bonds just aren’t getting it done anymore. While yields are increasing on bonds, that just means bond prices are going down,” he said.

While traditionally investors would have looked at bonds for yield and felt confident that their negative correlation to the equity markets would have balanced out a 60/40 portfolio, this isn’t happening now. In a very inflationary environment, equities are likely to outperform better than bonds, Piquard said.

“Covered calls replace existing stock exposure that you might have with an asset which is highly correlated to stocks, but it can earn a very attractive yield in this high-volatility environment,” he explained.

He believes that volatility is likely to remain for some time, given tighter monetary policy conditions and lower liquidity, something the Bank of Canada and, to a greater extent, the U.S. Federal Reserve have indicated.

A higher volatility means call options are typically more expensive, so firms such as Horizons ETFs can potentially generate high premiums, meaning their covered-call products could perform better and pay a more attractive yield compared to less volatile periods. 

Defensive option?

Piquard said that covered call options can be viewed as a defensive strategy because you are effectively reducing the volatility of the underlying securities. “The premium helps minimize the downside, but you’ve capped some of the upsides through the call sale,” he said.

There is also the benefit of a monthly yield compared to just the dividend if you owned the underlying stock, which can be a substantial difference. For example, the QQCC product, which tracks the tech-heavy Nasdaq-100® index, has a current indicated yield of 13.11% as at September 30, 2022, in a sector where dividends can be sparse. It is worth noting that while distributions made on monthly basis are generally comprised of the premium earned by the underlying options, that on a full-year tax basis, there is a strong possibility that the income generated will be taxed as Return on Capital, if the ETF has a higher annualized distribution than the capital return of the ETF.

Additional details about QQCC, including Product Facts and its Performance and Distributions, can be found on Horizons ETFs’ website at www.HorizonsETFs.com.

As with all investments, there are some risks in covered call products. This is where Horizons ETFs’ experienced team plays an active role. The strategy requires a balance between giving up too much upside versus generating yield – something they watch daily.

Best time for covered calls

Piquard said now could be one of the best environments that he has seen for covered calls for many years – not just because of the increase in volatility but also the lack of significant upside given central bank policy and inflation.

“You want to maintain your asset exposures, and this is a good way to get paid a good yield while you wait out this market,” Piquard said.

For financial advisors, even a modest allocation to covered call strategies can potentially help meet clients’ needs for income in today’s marketplace.

Disclaimers

Commissions, management fees and expenses all may be associated with an investment in exchange traded products managed by Horizons ETFs Management (Canada) Inc. (the “Horizons Exchange Traded Products”). 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 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 names and 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.

The financial instrument is not sponsored, promoted, sold, or supported in any other manner by Solactive AG nor does Solactive AG offer any express or implicit guarantee or assurance either with regard to the results of using the Index and/or Index trade name or the Index Price at any time or in any other respect. The Index is calculated and published by Solactive AG. Solactive AG uses its best efforts to ensure that the Index is calculated correctly. Irrespective of its obligations towards the Issuer, Solactive AG has no obligation to point out errors in the Index to third parties including but not limited to investors and/or financial intermediaries of the financial instrument. Neither publication of the Index by Solactive AG nor the licensing of the Index or Index trade name for the purpose of use in connection with the financial instrument constitutes a recommendation by Solactive AG to invest capital in said financial instrument nor does it in any way represent an assurance or opinion of Solactive AG with regard to any investment in this financial instrument.

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Certain statements may constitute a forward-looking statement, including those identified by the expression “expect” and similar expressions (including grammatical variations thereof). The forward-looking statements are not historical facts but reflect the author’s current expectations regarding future results or events. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from current expectations. These and other factors should be considered carefully and readers should not place undue reliance on such forward-looking statements. These forward-looking statements are made as of the date hereof and the authors do not undertake to update any forward-looking statement that is contained herein, whether as a result of new information, future events or otherwise, unless required by applicable law.

This communication is intended for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase exchange traded products (the “Horizons Exchange Traded Products”) managed by Horizons ETFs Management (Canada) Inc. and is not, and should not be construed as, investment, tax, legal or accounting advice, and should not be relied upon in that regard. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Investors should consult their professional advisors prior to implementing any changes to their investment strategies. These investments may not be suitable to the circumstances of an investor.

The views/opinions expressed herein are solely those of the author(s) and may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are generally based on information available as of the date of publication and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.