I own the BMO Canadian High Dividend Covered Call ETF (ZWC), which currently yields more than 7 per cent. However, most of the banks, pipelines, telecoms and other stocks in the exchange-traded fund do not yield close to 7 per cent. How is this possible, and does it mean a dividend cut is coming?
No, it doesn’t mean a dividend cut is coming. Since its inception in 2017, ZWC has consistently paid out between 10 and 11 cents per month in cash, and I don’t expect that to change. However, the way the ETF generates its juicy yield could exert a drag on the fund’s long-term performance.
Covered call ETFs such as ZWC supplement their dividend cash flow by selling, or “writing,” call options on a portion of their stocks. This brings in “premium” income, which allows the ETF to pay an above-average yield. (They’re known as “covered” calls because the ETF owns the stocks on which the options are written, as opposed to a “naked” option, in which the writer does not hold the underlying security.)
But option income isn’t a free lunch.
A call option is a contract that gives the option buyer the right to purchase a stock at a specified “strike price” before a certain date. The covered-call strategy works best in flat or falling markets. That’s because, when a stock is trading at or below the strike price, the option holder has no incentive to exercise the option, and the ETF simply pockets the premium.
During strong markets, on the other hand, covered-call ETFs typically underperform. When a stock rises above the strike price, the option holder will exercise the option to buy the shares. The ETF still gets to keep the premium income, but it suffers a loss on the stock, which it must sell at a price below the market.
In effect, when you invest in a covered-call ETF, you’re sacrificing potential future gains for the benefit of receiving additional income now. What’s more, covered-call ETFs generally have high management expense ratios. ZWC’s MER is 0.72 per cent, compared with about 0.5 per cent or less for many dividend ETFs and well under 0.1 per cent for many broad index ETFs.
The combination of using covered calls and charging relatively high expenses can hurt the returns of covered call ETFs. For the five years ended May 31, ZWC posted a total return – assuming all dividends were reinvested – of 4.17 per cent on an annualized basis, according to Bank of Montreal data. The plain-vanilla BMO Canadian Dividend ETF (ZDV), by comparison, had a five-year annualized return of 7.18 per cent. This isn’t strictly an apples-to-apples comparison, because the two ETF portfolios, while very similar, aren’t identical. But it does illustrate how covered call ETFs can lag over the long run.
Another example is the BMO Covered Call Canadian Banks ETF (ZWB). For the five years ended May 31, it posted a total annualized return, including reinvested dividends, of 4.3 per cent. That compares with 6.5 per cent for the BMO Equal Weight Banks Index ETF (ZEB), which has a lower MER and does not use covered calls.
If you need the additional income for living expenses, an argument could be made for allocating a portion of your portfolio to covered call ETFs. But if you don’t need the cash, you’ll likely be better off in the long run with regular ETFs.
I own the iShares S&P/TSX Composite High Dividend Index ETF (XEI). On my T3 slip for 2022 I discovered that eligible dividends accounted for just 15 per cent of the fund’s total distributions, with the vast majority consisting of capital gains. I then checked the Morningstar financial website, which also showed a relatively small contribution from dividends. Am I missing something?
Those numbers don’t seem right. Third-party financial websites often provide flawed data, which is why I always recommend going straight to the source, which in this case is ETF provider BlackRock Canada.
If you refer to the “2022 Distribution Characteristics” document available on the BlackRock Canada website (look under “Resources” and “Tax Centre”), you’ll note that XEI distributed $1.15733 of eligible dividend income per unit in 2022. This represented 99.2 per cent of the $1.16671 in total cash per unit it paid out during the year.
The ETF also declared a non-cash or “phantom” distribution of $1.9381, which reflected capital gains the fund reinvested but did not pay out to unitholders. Even though you didn’t receive these capital gains in cash, they were taxable in your hands. (Tax tip: Make sure you, or your broker, increase the adjusted cost base of your units by the amount of the reinvested distribution. Otherwise, you could end up paying more tax than necessary when you eventually sell your units.)
Including all cash and non-cash amounts, XEI distributed a total of $3.10481 in 2022. Of this, eligible dividends accounted for about 37.3 per cent, and capital gains made up about 62.4 per cent (The numbers don’t add up to 100 per cent because XEI also distributed very small amounts of foreign income and return of capital.)
I don’t know why the numbers in your T3 slip don’t line up with the data from iShares. It’s possible that some of the boxes on your tax slip include income from more than one investment, which would explain the discrepancy. It’s also possible that a mistake was made. I suggest you review your broker’s year-end summary of trust income, focusing on the amounts from XEI. Compare this with information from the iShares website to see if the amounts – adjusted for the number of units you own – match up. Follow up with your broker if you’re unable to reconcile the amounts.
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.