I am intrigued by the high yield of the Hamilton Enhanced Multi-Sector Covered Call ETF (HDIV-T). Is it a reliable source of income for retirees, or is it too good to be true? I would appreciate hearing about the pros and cons of this investment.
Based on HDIV’s most recent monthly distribution of 12.5 cents, or $1.50 on an annualized basis, the fund yields about 8.2 per cent – roughly three times the yield of the S&P/TSX Composite Index. Whenever a yield reaches into the high single digits, it’s imperative to dig deeper. In HDIV’s case – as with many similar high-yielding products – there is a lot going on behind the scenes that investors need to understand before taking the plunge.
Let’s start by looking at how HDIV is able to generate such a fat distribution. The ETF uses two main strategies, each with its own benefits and drawbacks.
First, HDIV holds a basket of seven other ETFs that employ a covered-call strategy to juice their own yields. In very basic terms, it works like this: When the underlying ETFs sell (or “write”) a call option on a stock they own (hence the term “covered”), the buyer of the option gets the right to purchase the stock from the ETF at a certain “strike” price for a specified period of time. In exchange for this privilege, the option buyer pays the ETF a “premium” that the fund can use to generate a higher distribution.
Selling call options is not a free lunch for the ETF, however. If the stock price is stable or falls, no biggie: The buyer of the option won’t exercise it and the ETF will simply pocket the premium. But if the underlying stock rises above the strike price, the option holder will call away the stock. The ETF will still keep its premium, but it won’t participate in the full upside of the share price. Generally, you can think of selling call options as a way to generate income now at the expense of capital gains later. That’s one reason why, on a total return basis, many covered-call funds lag similar ETFs that don’t use a covered-call strategy.
The second method that HDIV uses to enhance its yield – and to potentially overcome the performance drag from writing covered calls – is leverage. HDIV can borrow and invest up to an additional 25 per cent of the equity in the portfolio, which will boost the fund’s performance in a rising market. But remember that leverage cuts both ways: In a falling market, HDIV will drop more than its underlying investments. The amount of leverage here is modest, but investors still need to be mindful of the risks.
“We call 25 per cent the Goldilocks amount of leverage. It’s enough to matter, but it’s not enough, in our opinion, to fundamentally alter the risk profile of the portfolio,” Robert Wessel, managing partner and co-founder Hamilton ETFs, said in an interview.
HDIV has another key difference compared with most other covered-call ETFs: diversification. Instead of focusing on one sector, it invests across seven industries – energy, banks, utilities, insurance, health care, technology and gold mining. It does so by holding seven sector-specific covered-call ETFs from other providers – BMO Global Asset Management, CI Global Asset Management, Harvest Portfolios Group and Horizons ETFs. (Note: In February, Harvest launched a similar product, the Harvest Diversified Monthly Income ETF (HDIF-T), to compete with HDIV. Unlike HDIV, HDIF holds only other Harvest funds.)
Costs are another thing to keep in mind. HDIV has a management fee of 0.65 per cent and an estimated management expense ratio (MER) of about 0.8 per cent. But that is on top of the MERs of the underlying ETFs, which also average about 0.8 per cent. When an ETF holds other ETFs from the same company, investors only pay the one MER. But that’s not the case here.
What about performance? Well, given that HDIV has only been around for about eight months, it’s a bit early to judge. But, so far, results have been good: From its listing on July 21 through March 17, the HDIV has posted a total return of 17.5 per cent, assuming all distributions had been reinvested. That compares with a total return of about 10.2 per cent for the S&P/TSX Composite Index over the same period, also including distributions.
Evidently, the combination of a high yield and leveraged returns appeals to many investors. Helped by its strong performance, the fund now has more than $150-million of assets under management. In February, the company launched a similar ETF based on the U.S. market, the Hamilton Enhanced U.S. Covered Call ETF (HYLD-T), which has about $60-million under management.
Clearly, HDIV’s use of leverage has been a benefit during a sustained period of rising stock prices. Just remember that leverage won’t be so kind when markets hit a rough patch – as they inevitably will.
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.
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John Heinzl