I would like your opinion of two products with high dividend yields. The first is the Hamilton Canadian Financials Yield Maximizer Exchange-Traded Fund HMAX-T, which yields more than 15 per cent. The other is Financial 15 Split Corp. FTN-PR-A-T, which pays about 9 per cent. Are these yields too good to be true?
Just as restaurants know that diners love big portions, the financial industry has long understood that investors have a weakness for juicy yields. Before you give yourself a case of investment indigestion, let’s look at how the sausage is made, so to speak, so you can understand the risks of consuming these and other high-yielding products.
The Hamilton Canadian Financials Yield Maximizer ETF is a relatively new player on the high-yield scene, having been launched a little more than a year ago. It holds a basket of 10 of the largest Canadian financial institutions, primarily banks and insurers. All of these companies pay dividends, but their yields average just 4.3 per cent, which is less than one-third of the ETF’s 15-per-cent payout.
How does the fund bridge that yawning gap? Answer: It sells covered call options on stocks in its portfolio. A call option gives the buyer the right to purchase a stock at a specified “strike” price before a certain date. (It’s referred to as a covered call because the fund owns the securities on which the options are sold.)
Selling calls to earn “premium” income is common with high-yielding ETFs, but HMAX’s options strategy is more aggressive than most. For one thing, it sells – or writes – call options on about half of its portfolio, which is higher than many funds. For another, it focuses on writing at-the-money options, in which the strike price is at or near the market price of the stock, as opposed to out-of-the-money options, when the strike price is higher than the current market price.
Selling at-the-money calls generally brings in more premium income, because option buyers are willing to pay more given the higher probability that the option will be exercisable at a profit. The downside, however, is that there is a greater risk that the stock will be called away, which limits the ETF’s potential gains in a rising market.
HMAX’s returns bear this out. From the ETF’s inception on Jan. 20, 2023, through Jan. 31, 2024, it posted a total return, including dividends, of negative 0.32 per cent on an annualized basis. In other words, while HMAX was pumping out a fat monthly dividend, the income was more than offset by a falling unit price.
Compare that to the iShares S&P/TSX Capped Financials Index ETF (XFN), which holds many of the same securities but does not use a covered-call strategy. XFN posted a total return of about 6.5 per cent over the same period.
Robert Wessel, managing partner of Hamilton ETFs, said HMAX’s underperformance can be explained, in part, by differences in the composition of the two ETFs. For example, HMAX was overweight banks during a sluggish period for these stocks. And certain companies that have performed well recently, such as Fairfax Financial Holdings Ltd. (FFH) and Brookfield Asset Management Ltd. (BAM), are included in XFN but excluded from HMAX because they do not have liquid options markets.
“I can say with great confidence, the impact of the options strategy was significantly less than the 6-percentage-point difference in returns cited,” Mr. Wessel said.
Covered call writing may work well in flat or falling markets, but in general it does more harm than good, critics say.
“I consider the … strategy to be a gimmick to snare the unwary,” James Hymas, president of Hymas Investment Management Inc., said in an e-mail. “I have never seen any evidence whatsoever that any single one of these covered call enthusiasts are any good at writing and trading options. And if you’re not good at it you will give up more in foregone capital gains than you gain in option premia.”
What’s more, HMAX’s current monthly distribution of about 17.5 cents is not guaranteed. As the company says on its website: “Hamilton ETFs may, in its complete discretion, change the frequency or expected amount of these distributions.”
Now, let’s look at Financial 15 Split Corp.
Like HMAX, Financial 15 Split invests in a basket of Canadian banks and insurers, plus a handful of U.S. names. But its structure is fundamentally different.
Split corporations issue two types of shares to the public: preferred shares and capital (or class A) shares. The preferreds are more conservative, because they have first claim on the dividends from the underlying stocks. The preferreds also get first dibs on the capital of the portfolio, up to the preferreds’ issue price (of $10 a share in FTN.PR.A’s case), upon termination of the split share corporation.
Split capital shares, on the other hand, are much more volatile. Because they are entitled to all of the value in the portfolio above the amount allocated to the preferreds, the class A shares are in effect a leveraged play on the underlying stocks. If the portfolio rises in value, the capital shares will post an even bigger gain. But if the underlying stocks fall, the capital shares will suffer an even bigger loss. Capital shares often pay dividends as well, but these can be suspended if the total value of the split corporation falls below a certain threshold. That’s what happened in 2020, when Financial 15 Split’s class A shares skipped dividend payments for nine consecutive months.
In contrast, split preferred dividends are generally safe. In FTN.PR.A’s case, however, there’s an added wrinkle: The manager, Quadravest Capital Management Inc., has hiked the dividend on the preferreds three times in the past four years, by a cumulative 68 per cent. That’s an enormous increase, and it’s the reason the preferreds now yield north of 9 per cent, based on annualizing the most recent monthly dividend.
“I believe that Quadravest boosted the preferred share dividend to such a high level because they wanted to keep the preferred share price high” to facilitate the sale of additional shares through the company’s “at-the-market equity program,” Mr. Hymas said. The ATM, which the company renewed in December, allows Financial 15 Split to issue shares to the public from time to time at the company’s discretion.
But here’s the thing: The dividend – which is currently about 7.7 cents a month or 92.5 cents annually – won’t necessarily remain at its current level forever. The dividend rate is set annually at the discretion of the board and is subject only to a minimum yield of 5.5 per cent until 2025, when the split corporation is scheduled for termination on Dec. 1 of that year (subject to a further five-year extension).
If Quadravest were to cut the preferred dividend to the minimum of 5.5 per cent (based on the issue price of $10) in December, 2024, investors who hold the shares from now until maturity in December, 2025, would have an effective annual yield of just 6.75 per cent, Mr. Hymas said.
I’m not saying Quadravest will cut the dividend, just that it is a possibility.
Reflecting this and other risks, DBRS Morningstar this week downgraded FTN.PR.A’s shares to Pfd-4 (high) from Pfd-3. Preferred shares rated Pfd-4 “are generally speculative, where the degree of protection afforded to dividends and principal is uncertain, particularly during periods of economic adversity,” the rating agency said.
DBRS Morningstar cited, among other factors, FTN.PR.A’s recent dividend increase in December and a decline in the dividend coverage ratio to 0.37 times, meaning the dividends generated by the underlying portfolio of stocks cover just 37 per cent of the payout to preferred shareholders.
“To supplement the portfolio income, the company may engage in covered call options and put option writing on all or a portion of the shares held in the portfolio,” DBRS Morningstar said.
Bottom line: Before you stuff your portfolio with high-yielding securities, remember that there is no free lunch with investing.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.
John Heinzl