Understanding Covered Call ETFs

Covered call ETFs are marketed as options for generating a high monthly income, but experts warn that investors should approach these products with caution. It’s important to not get swept up in the excitement surrounding these funds without considering the potential drawbacks.

These ETFs operate by holding a selection of stocks and earning revenue through the sale of call options on those stocks. They’re often advertised as appealing because they can produce income, lessen volatility, and allow investors to engage with covered call strategies without needing to dive into the complexities of individual transactions.

However, if investors lack a solid understanding of how the covered call strategy actually works, they might be enticed by the high yields that these funds promise, completely overlooking possible long-term pitfalls. Financial planner Anita Bruinsma from Clarity Personal Finance in Toronto shares that while these ETFs do provide regular income, many holders may not realize that a significant portion of those payments isn’t truly profit generated by the fund.

“Actually, they just return your own money to you,” she explains. “If you’re unaware of the details, you might think you’re benefiting from the fund’s earnings.” Bruinsma points to a specific fund, the Balanced Income and Growth ETF (HBIE), promoting a distribution yield of 10.37%, especially when five-year GICs yield about 3% and high-dividend options roughly 4.5%.

But there’s a catch. “Generating that kind of income consistently would be tough for any portfolio manager,” she notes. A deeper examination shows that while the fund distributed $1.80 per unit in cash in 2024, only 6.07% of that came from Canadian dividend revenue—it’s not from interest income, she emphasizes. In fact, 52% of what investors received was simply a return of capital, which means they’re effectively getting back their own initial investments.

This return of capital reduces the cost basis of the units they hold. Consequently, when these units are sold, investors may face capital gains taxes even though they think they’re enjoying a 10% income from the fund; in reality, the genuine income yield might be closer to 4.8%. “They market it as a fund that offers monthly cash flow. Who wouldn’t be drawn to that?” she adds.

Aravind Sithamparapilla, another financial planner from Ironwood Wells Management Group in Ontario, notes that when contrasting covered call strategies to traditional buy-and-hold methods, buy-and-hold strategies often yield a higher gross profit.

Potential Limitations of Covered Call Strategies

While covered call ETFs are designed to perform well in stable or declining markets—thanks to the extra income generated through option sales—Sithamparapilla cautions that these strategies have their own risks. Predicting market movements over the long term isn’t an exact science.

Moreover, using covered calls comes with opportunity costs. The extra revenue from selling call options can lead to missed gains if stocks are sold at lower prices, especially if the market suddenly rises. In certain scenarios, what’s lost could outweigh the income earned.

For a concrete comparison, Sithamparapilla looks at the BMO Equal Weight Banks ETF (ZEB.TO) alongside the BMO Covered Bank of Canada Fund Series ETF (ZWB.TO). Both consist of equally weighted bank stock portfolios, but ZWB incorporates a covered call strategy.

Sithamparapilla reports that since ZWB’s launch on June 20, 2011, it has delivered a total cumulative return—including price increases and dividends—of 211.2%, significantly outperforming ZEB. “In the past 14 years, the covered call version would have yielded more than three times the return of the non-covered call version,” he concludes.