While 2022's bear market was a watershed year for the options strategy, ETFs continue to capture flows
2022 was a landmark for Canadian covered call ETFs. In the midst of a bear market where fixed income and equities abandoned their negative correlation and dove headfirst into the pit together, Canadian investors and advisors sought refuge anywhere they could. Covered call ETFs were one such place of refuge. These ETFs tend to hold baskets of equities overlayed with a covered call option writing strategy — though in recent years fixed income covered call ETFs have been launched. They cap upside by selling options, but generate high premiums especially during periods of volatility. Those premiums are passed on as income, which contributes to total returns and helped a lot of investors eke something out of a bad year.
Since the 2022 bear market ended, however, these ETFs have continued to see flows. The total options category of Canadian ETFs has grown its AUM from $10 billion in 2020 to $24 billion today, which can largely be attributed to these covered call products. Kaitlin Thompson, VP of Product Strategy at Evolve ETFs, explained why she thinks that continues to be the case. Whether due to volatility offsets, increasing sophistication of product offerings, or just Canadians’ love of yield, it seems like these products aren’t going anywhere.
“What’s interesting about covered call funds is that people tend to gravitate more towards them and other dividend paying strategies when rates are coming down,” Thompson says. “We have a lot of assets in our high interest savings account ETFs or other cash products, and short term rates have been coming down. We’re seeing a lot of investors start to rotate out of their short-term cash-like solutions into the equity market, the fixed income market, or into some covered call funds because the delta of what you can earn has gotten bigger.”
In anticipation of this falling rate cycle a number of Canadian ETF issuers also released the first set of fixed income covered call products. These products hold portfolios of fixed income ETFs, overlaid with covered call options to generate higher yield. This innovation, along with new products targeting specific sectors and timely areas of the market has continued to drive interest from investors and advisors.
There has also been a growing sophistication in the nature of these covered call strategies. Early iterations of covered call ETFs employed systematic writing strategies, writing calls on the same level of the portfolio for each expiry date. This left them inflexible and more prone to underperformance. More managers, however, are taking active approaches to their options strategy, writing at lower levels when premiums are higher to retain more upside exposure.
In addition to the appeal of high yield products in a falling rate environment, Thompson is quick to emphasize the fact that options will earn higher premiums during periods of volatility. Since falling rate environments reflect weakening underlying economies, there should be some additional volatility emerging from that slowdown in the coming months, which may give covered call strategies additional advantage.
One of the more curious aspects of the popularity of covered call ETFs is their disproportional presence in the Canadian market. While the US market has plenty of these products, options ETFs make up a higher proportion of total AUM in the Canadian market than in the US. Thompson says that her own team will sometimes wonder why Canada seems such fertile ground for these strategies, and she has a few hypotheses. First and foremost is a Canadian love of yield. Many of Canada’s most capitalized sectors and companies are known more for their high dividend yield than their market returns. Adding covered calls seems like a way to enhance that yield a little further, even if it comes at the expense of market upside.
That capped upside is a common critique levelled at these ETF strategies. While they pay some yield, they will underperform a bull market. Thompson notes that these strategies may not be for everyone. An investor with a longer time horizon or who wants more growth may prefer just a pure-play equity exposure. Investors who prioritize income, however, may prefer a covered call allocation. As advisors discuss these products and strategies with their clients, Thompson emphasizes the importance of finding the right fit.
“Ultimately it’s about setting expectations,” Thompson says. “That’s something we work a lot with when we’re talking to advisors. A covered call strategy is not for everyone, you need to understand exactly what you’re signing up for. You might sell some upside in a very strong performing market, but you get that enhanced income and slightly lower volatility and drawdown throughout your investment. I think setting those expectations is important.”
