BMO Covered Call Canadian Bank ETF Analysis

I have to admit, I get a large amount of pleasure getting paid a dividend or distribution for owning an investment. While I don’t think it’s necessary to get paid to wait, I do admit feeling a certain fondness for income. Maybe I’m getting risk adverse in my old age, or maybe I’m just realizing my fixed income portfolio is sorely lacking. Whatever the reason, I’m hungry for yield lately.

Or maybe it’s french fries I’m hungry for. I’m not too sure, but a plate of fries sounds pretty delicious right now.

Anyway, I happened to stumble upon a BMO ETF that has an interesting strategy. The ETF holds mostly shares in the Canadian banks, while writing long term calls on the shares it already owns (which is called writing a covered call). Since the fund yields close to 10%, I have to check this bad boy out.

All info comes direct from BMO’s website.

The Basics

Ticker Symbol: ZWB

Price (Closing price on March 30): $16.31

Net Asset Value (March 30) $16.29

Portfolio Yield: 9.56%

Annual Management Fee: 0.65%

RRSP/TFSA Eligible: Yes

Units Issued: 4,800,000

Date Started: Jan 28, 2011

As you can see, the fund is brand new, only being traded for 2 months. This fund holds approximately 50% of its assets in BMO’s equal weight banks ETF, with the rest being spread out over the 6 main Canadian banks. Then, a very small percentage of the portfolio is used to buy the call options on certain banks.

The annual management fee is a little high at 0.65%. There is a degree of active management in this fund with the call writing, so that could be good or bad, depending on your perspective.

The Fund’s Strategy

How does the fund have such a high yield? And how does it make money writing these calls? First of all, a primer on covered calls.

If an investor already owns a stock, then selling a covered call is a way to get income from that position, providing the stock price remains fairly steady or goes up over time. I’m going to let BMO explain this one, take it away guys.

The covered call option strategy allows the portfolio to generate income from the written call option premiums in addition to the dividend income from the underlying stocks.

As an example, consider a portfolio that consists of 100 shares of Bank of Montreal (BMO) at a current price of $60, for a total value of $6,000. At the money (ATM) call options (exercise at $60) that expire in one month are valued at a premium of $1.50 per contract. To implement a covered call strategy, the portfolio writes call options on 100 BMO shares and receives $150 in premium. If the stock price remains at $60, the calls are not exercised, and the portfolio benefits from the premium received. The new portfolio value is $6,150.

Still with me? Good. Now what happens if the price of the underlying stock goes down?

If the stock price drops to $58.50, the calls are not exercised, but the portfolio value drops. The new portfolio value is $6,000 ($5,850 + $150) which is the break even point. The portfolio will devalue at any price below $58.50.

If the share price goes up beyond $61.50, the portfolio will miss out on some potential returns, since the gains from the call option are limited to $1.50.

Distribution Risks

The whole point of the strategy is to exchange current income for upside potential. During periods where bank stocks do well, this strategy will under perform the index. An investor looking for income will make that trade off, assuming the income stays consistent.

I’m not an expert on options by any means, but I’m assuming the income from this fund is dependent on the management writing effective calls. I presume these calls are short term in nature, meaning the premiums from them aren’t very much, but are relatively safe due to the short time period. Looking at the fund’s current holdings, we see call options expiring on the 16th of April. I assume the fund managers are writing calls each quarter.

From what I can see, the only major risks for distributions are management completely dropping the ball on the covered calls, liquidity in the options market drying up, or a cut in the dividend for one of the underlying banks. While these risks should be kept in mind, I don’t see any being a very realistic scenario.

Another concern is the lack of track record for the portfolio. Investors have used covered calls in just this manner for a long time. The strategy has a long track record. But sometimes, stuff will happen that even astute investors won’t have seen coming. That’s always a risk when investing in an actively managed fund, a risk that becomes a little more dangerous in a new fund.

Will I Buy It?

I’m thinking about buying this one for my non-registered portfolio. Since any returns will be in the form of dividends or capital gains, this is a good way to get income that will be taxed favorably.

I’d recommend only making this ETF a small percentage of your fixed income holdings. The yield is telling an investor that this strategy isn’t risk free. I think over time it will work out okay. This strategy is a little more risky than government bonds, that’s for sure.

The fund pays distributions monthly, with the next ex-dividend date not until April 26th. There’s no need to rush into this one right away. If the bank stocks decline before the end of April, there might be an opportunity to buy this fund with a yield over 10%.

I do not own shares in the BMO Covered Call Canadian Bank ETF. If I do buy some, I’ll definitely let you guys know.

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