Are dividend stocks, preferred shares, income trusts, and real estate investment trusts (REITs) not fully meeting your passive income needs? Are you looking for even higher yields?

Well, the Canadian exchange-traded fund (ETF) industry has a possible solution: the covered call ETF. These ETFs use derivatives called covered calls to produce higher-than-average income potential that is usually paid out on a monthly basis.

However, these ETFs can be more complex and difficult to understand than your average ETF. If you’re looking to start investing in covered call ETFs, we’ll explain what you need to know.

What is a covered call ETF?

ETFs are investment funds that hold a diversified “basket” of assets, such as stocks, bonds, or commodities. As their name suggests, ETFs trade on exchanges. When an investor buys shares of an ETF, they receive exposure to the returns and risk of the basket of assets.

A covered call strategy involves the use of options, which are derivatives that give investors the right, but not the obligation to purchase a security at a set price (the strike) at a set date (the expiry).¹ Specifically, a covered call strategy involves holding a long position of at least 100 shares in an asset (like a stock) and selling (or “writing”) a call option on the same asset.

By doing so, the investor pockets a cash premium, the size of which is dependent on factors like the time until expiry, volatility of the underlying asset, and strike price. How close the strike price is to the current market price of the asset is known as “moneyness,” and it can be in-the-money (under), at-the-money (the same), or out-of-the-money (higher).²

By selling covered calls, the call writer is potentially giving up future upside potential in return for an immediate cash premium. If the market price of the underlying asset goes above the strike price before or at expiry, the option is “in the money,” and the investor will have to sell 100 shares of the underlying stock at the strike price for each covered call contract sold.

A covered call ETF simply does all this on an investor’s behalf. The ETF assembles and manages a portfolio of assets, sells calls on a portion or all of it based on various rules, and packages it into an ETF. Investors who buy a covered call ETF, therefore, receive heightened income potential from the premiums without having to sell options themselves.  

Thu, the yield from a covered call ETF is two-fold, consisting of options premium income and dividends. As with any other ETF, covered call ETFs charge a management expense ratio, or MER, expressed in percentages. Think of this as the fee you pay annually to the ETF manager. For example, a 0.50% MER would result in around $50 in annual fees for a $10,000 investment.

Top Canadian covered call ETFs

The following Canadian covered call ETFs currently possess the highest assets under management, or AUM, as of writing:

Data accurate as of April 24, 2023

BMO Covered Call Canadian Banks ETF

ZWB offers investors in Canada’s “Big Six” banks an income-oriented alternative. The ETF holds all six of Canada’s big banks in equal weightings and then sells covered call options on them to produce increased monthly income potential in addition to the bank’s regular dividend payments.

BMO Covered Call Utilities ETF

Investors looking to augment the dividends received from North American utility stocks can use ZWU for enhanced exposure. This ETF holds a portfolio of 76 utility stocks, which also include some energy stocks in the pipeline industry. Around two-thirds of this ETF’s portfolio is held in Canadian utility stocks, while the rest are from the U.S.

BMO Canadian High Dividend Covered Call ETF

For a more diversified approach to covered call investing, investors can opt for ZWC, which holds a portfolio of 93 Canadian dividend stocks augmented by a covered call overlay. Investors can therefore not only participate in the dividend income, but also earn premiums from the covered calls. ZWC’s portfolio mostly consists of financial sector companies, followed by energy, telecoms, and industrials.

Pros of investing in covered call ETFs

Covered call ETFs have several advantages that make them popular investments among Canadian investors:

• High income potential: Covered call ETFs tend to payout much greater yields than dividend stocks or other income-generating assets.
• Monthly income: Covered call ETFs often make monthly dividend payments as opposed to quarterly.
• Outperformance: Covered call ETFs can outperform regular ETFs during high-volatility, sideways trading market conditions.

Cons of investing in covered call ETFs

However, covered call ETFs are not perfect investments by any means. They have some disadvantages, which include:

• Capped performance: Over long periods of time, especially after bull markets, covered call ETFs tend to underperform regular ETFs even with the dividends reinvested.
• High fees: Covered call ETFs tend to charge much higher expense ratios than regular ETFs.
• No crash protection: The premium from covered call ETFs can reduce volatility but won’t be an effective hedge during a market crash.

Are covered call ETFs right for you?

Covered call ETFs are a very specialized ETF product best suited for investors with very specific income objectives in mind. If your goal is producing a consistent stream of monthly income without needing to sell shares, then a covered call ETF could work.

However, keep in mind that these ETFs can underperform regular ETFs over long periods of time, especially during bull markets. This is an unavoidable consequence of the covered call strategy, which basically converts future returns into present income.

Finally, keep in mind that by buying a covered call ETF, you’re still subject to the risks of the underlying assets. For example, an investor who buys a covered call ETF holding Canadian bank stocks is still exposed to the risks of investing only in bank stocks, so consider diversifying further.