A screw is not a nail

Some ETFs that employ derivatives are receiving critical press and regulatory scrutiny, so we’re examining them in this series.

They may look similar, but…

Covered-call ETFs with monthly distributions are not income products, even if those distributions seem like dividends or interest. The “yields” from preferred shares or common stocks are different than bond and covered-call yields. Look at the underlying components—bond interest is more reliable than preferred dividends, which are more permanent than common-stock dividends, which are significantly more stable than option premiums.

Time is a bigger factor in evaluating an option than it is for preferred shares. With options, both the expiration date and strike price relative to the market price are critical. Even the sourcing of income is different. Option premium cash flow is considered capital gains and taxed at a higher rate than dividends.

Covered-call ETFs are all the rage: when capital markets are unsettled and yields are low, the promise of higher returns from selling call options against stagnant equity holdings is attractive.

ETFs have democratized access to this tactic.While people need margin accounts to execute covered- call trades themselves, ETFs make this unnecessary. Calls give the owner the right to buy a stock at a predetermined price (strike) for a predetermined time (until expiration). Puts give the right for the owner to sell stock under similar constraints. Puts and calls are exchange-traded derivatives that, while useful in altering risk, can add costs.

What is a covered call?

Buying a stock and selling the right to buy it from you is the principle of a covered call. Do this if you:

• want to sell the stock anyway;
• believe the person is willing to overpay for the right.

Price and time will influence your decision. You must:

• be willing to sell the stock at the strike price within the expiration period;
• think the call buyer is too optimistic for the stock’s prospects through expiration; and
• want to protect your position from some price decline.

Covered calls should improve returns in trendless and modestly declining markets, and reduce risk (standard deviation). An example is BMO Covered Call Canadian Banks (ZWB), the covered-call ETF with the most AUM in Canada as of December 19, 2011 (see sidebar, “ZWB protects”).

ZWB PROTECTS WITH SLIGHTLY LESS RISK THAN ZEB

FEB. 1, 2011 TO DEC. 9, 2011	ZWB	ZEB
Total return	-3.75%	-4.33%
Standard deviation	17.46%	18.27%

Some ETFs write calls on all holdings (BMO; Horizons Betapro), and some on only 25% (XTF). Some write out-of-themoney (BMO; Horizons Betapro), and some at-the-money (XTF). What are the various risks?

The chart “Three financial services covered-call ETFs”, below, indexes these ETFs from June 3 to December 9, 2011.We can see:

1. Writing against 100% of positions (BMO’s ZWB and Horizons Betapro’s HEF) versus 25% (XTF’s FXF) provides better downside protection;
2. Protection during periods of sharp market declines (July to August) can be difficult. Constrained liquidity and the cost of “rolling down” (buying back short call positions and reselling at a lower strike price) can limit effectiveness.

Three financial services-covered-call ETFs

When markets rise quickly, ETFs with only 25% of positions “overwritten” should provide more upside.The difference between the more conservative at-the-money strike price of XTF—albeit on a smaller portion of the holdings—and the slightly out-of-the money price of BMO and Horizons Betapro is likely to be similar to the difference between the at-the money and 2% out-of-the-money for the CBOE S&P 500 Buy-Write Indexes (see sidebar, “Less risk”).

LESS RISK WITH AT-THE-MONEY INDEX

	S&P 500 Total Return	CBOE S&P 500 at-the- money Buy-Write Index	CBOE S&P 500 2% out-of-the money Buy-Write Index
Return	9.6%	9.6%	12.7%
Standard deviation	18.2%	12.7%	14.5%

Always sell volatility

Call-writing strategies exploit the spread between implied and realized volatility. This is the difference between the fear of losing (puts), the greed of making money (calls), and reality.Over time, selling calls has been more profitable than buying them, because capital markets always fear something. Covered-call ETFs allow investors to exploit pricing inefficiencies and bend risk around their equity underpinnings.