What are we looking for?
Well-rated covered call or “enhanced yield” mutual funds and ETFs available in Canada
The screen
When interest rates dropped during the pandemic, investors saw a distinct gap in cashflow generating investments (that traditionally came from bonds), and a need to supplement distributions from an investment portfolio. Over the ensuing years (2022-today), a whopping 42 “enhanced yield” or covered call ETFs and mutual funds were launched in Canada. These investments typically write call options to generate extra income for investors. The covered call strategy obtains this extra income by “selling” the right to buy a stock held in the portfolio at a stated price in exchange for a small premium. This premium is paid out to investors in the form of capital gains (or “enhanced yield”). As we know, there is no free lunch in investing. The tradeoff here is that if that stated price (the strike price) is exceeded, whoever bought the rights to the stock will indeed ‘call’ the option, and the portfolio manager must either deliver the stock or pay the equivalent of the stock’s current worth to the option owner. This transaction has the effect of capping a stock’s returns. In other words, if the price of the stock on which the option is written reaches a certain point (higher than today) then no further gains can be made from that stock due to the option. Here, the portfolio manager is making a calculated bet that the stock’s price doesn’t go above a certain threshold, in exchange for a small premium. The amount of that premium is largely dictated by the stocks implied volatility, and of course market expectations.
There is a distinct tax benefit of this type of strategy. Premiums generated from options are taxed as capital gains in Canada, which will have a lower tax effect than dividends (from stocks) and interest income (from bond coupons). The tradeoff, of course, is the capping of gains on a particular position mentioned above. Investors will also notice that these types of investments demand a higher fee, due to the complexity and also a potentially higher turnover in the portfolio which increases trading costs that investors pay for through fees.
Today, we seek covered call strategies where the tradeoff has paid off for investors (or we believe will do so in the future). To do this I used Morningstar Direct to screen for covered call or “enhanced yield” mutual funds and ETFs (of which there are 77 today) that have:
- Outperformed category peers on an after-fee risk-adjusted basis (using the Morningstar rating for Funds or “star” rating of 4-stars or better). Remember that this rating compares funds to their category peers. Covered call strategies do not have their own formal category. Instead, they sit amongst all other traditional funds and ETFs based on their underling asset allocations (stocks, bonds, and geographic exposure). In essence, the star rating is comparing these covered call strategies to all others that invest in the same types of underlying assets.
- or that Morningstar believes will outperform category peers in the future by screening on a Morningstar Medalist rating of either gold, silver or bronze. This denotes Morningstar’s assessment of people (quality and experience of the management team), process (the consistency of strategy and risk management approaches) and parent (the stewardship qualities of the fund company).
The initial search for the 77 funds and ETFs was conducted through keyword search on the funds’ legal names.
What we found
The funds and ETFs that qualified in the screen are listed in the table accompanying this article, alongside their trailing performance, MERs, inception dates, tickers, and ratings.
This article does not constitute financial advice, it is always recommended to conduct one’s own independent research before buying or selling any of the funds mentioned in this article.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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