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Exchange-traded funds (ETFs) continue to gain popularity, not only among growth-focused investors, but with income-oriented investors as well.
In this blog we discuss covered calls strategies, which may provide opportunities for income-seeking investors. This approach may not be for everyone, so it is important to consider both the benefits and potential drawbacks of these ETFs.
Covered calls explained
A call option is an agreement to sell a security at a predetermined price (the strike price), within a specified timeframe (expiration). If the seller of the option does not already own the underlying security, they face the risk that it can overshoot the strike price, in which case they must buy the security for more than they have agreed to sell it, generating a loss.
If the seller of the call already holds the security, it’s considered a “covered” call, which limits risk for the seller.
The pros of covered call ETFs
There are several potential benefits to an ETF using a covered call strategy.
Income generation: Covered call ETFs are designed to generate income for investors. They do this by selling call options on the underlying stocks they hold. This income can provide a steady cash flow, making them appealing to income-oriented investors.
Reduced volatility: The act of selling covered calls can help mitigate some of the volatility associated with stock ownership. When an ETF writes a call option on a stock it holds, it collects a premium, which provides a cushion against potential stock price declines.
Enhanced total return: By generating income from call option premiums, covered call ETFs may enhance the total return of an investment portfolio. This can be particularly attractive for investors seeking both income and potential capital appreciation.
Diversification: Covered call ETFs often hold a diversified portfolio of stocks, spreading risk across various sectors and industries. This diversification can help reduce the impact of poor performance from individual stocks.
The cons of covered call ETFs
There are also potential drawbacks.
Limited upside potential: One of the primary drawbacks of covered call strategies is that they cap the potential for capital appreciation. When an ETF sells a call option on a stock it holds, it agrees to sell that stock at a predetermined price (the strike price) if the option is exercised. This means that the ETF may miss out on significant gains if the stock's price rises significantly above the strike price.
Complexity: Covered call strategies can be complex, especially for investors new to options. Understanding how call options work, strike prices and expiration dates is essential for investors in these ETFs.
Higher costs: Like other ETFs, covered call ETFs charge management fees. Investors should be aware of these fees and how they can affect overall returns. It’s essential to compare fees when selecting a covered call ETF. Additionally, covered call strategies typically have higher trading costs, as indicated by a higher total expense ratio (TER), which can act as an additional drag on performance.
Risk of assignment: When a call option is exercised, the ETF must sell the underlying stock at the strike price, potentially leading to the loss of a stock that had appreciated in value. This risk is heightened in rapidly rising markets.
Tax considerations for covered call ETFs
Treatment of premiums: In Canada, the premiums received from writing covered call options are generally considered capital gains. These capital gains are typically 50% taxable at your marginal tax rate. This can be more tax-efficient than interest income or other forms of regular income, which are fully taxable.
The capital gains generated from selling call options can potentially offset capital losses in your portfolio, reducing your overall tax liability.
Tax-efficient distributions: Many covered call ETFs in Canada aim to provide tax-efficient distributions to investors. To do so, their distributions include a combination of eligible dividends, capital gains and return of capital.
Return of capital component: The return of capital component is not immediately taxable as income. But it reduces your adjusted cost base (ACB) of the ETF shares. Taxes on this portion are deferred until you eventually sell your ETF shares. We discussed return of capital in a previous article.
Keep accurate records: For non-registered accounts, it's essential to maintain accurate records of all your covered call ETF transactions, including premiums received and distributions. This information will be critical for tax reporting purposes, especially when calculating your adjusted cost base.
Get professional advice: Tax rules can be complex and the tax treatment of your investments may vary based on your individual circumstances. Consulting with a tax professional or financial advisor who specializes in Canadian taxation can help you navigate these complexities.
Consider registered accounts: If you're concerned about the tax implications of covered call ETFs, consider holding them in a registered account, like a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA). These accounts can provide tax benefits and shield your investments from certain tax consequences.
Covered call ETFs can be attractive for income-focused investors who are willing to trade some potential capital appreciation for steady income. On the other hand, investors seeking higher growth may find covered call ETFs less appealing.
For best results, consult with a tax professional or financial advisor who can help you navigate the specific tax rules. They can make sure your investment choices align with your financial goals and tax efficiency objectives.
Commissions, management fees, brokerage fees and expenses all may be associated with Exchange Traded Funds. Please read the prospectus before investing. Exchange Traded Funds are not guaranteed, their values change frequently and past performance may not be repeated.
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