Ever since Exchange Traded Funds or ETFs hit the market a few decades ago, they have been touted as an affordable way to invest and diversify your portfolio. ETFs are exposed to almost all investment areas, from equity income strategies to sectors such as healthcare and technology to global and emerging markets, which makes them very attractive to both new and experienced investors.
If you’re like most investors, you likely have a few ETFs in your investment portfolio (Canadian ETFs make up $ 289.2 billion, or more than 13% of mutual funds). But maybe you didn’t see them as a source of income. We’re going to go over some innovative ways to get cash flow from your stock portfolio through ETFs that use enhanced income strategies, as well as more popular dividend and REIT ETFs.
Enhanced Income ETFs
This involves one of the more complex investment strategies so let’s start by breaking it down.
It starts with the underlying portfolio, where the fund manager can invest in a broad dividend portfolio or a focused sector or industry strategy. It can help to have a strong dividend base to support cash flow from the ETF, such as bank stocks, but the fund can also invest in a more growth-oriented sector like technology stocks. Note that this portfolio will be a significant contributor to the ETF’s return.
The fund manager then uses a covered call strategy to increase the cash flow from the portfolio. This improvement means that any potential excess of the portfolio is sold for cash in the form of call option premiums. For income-oriented investors, this can be a very attractive compromise.
When you sell a call option, the contract has a price at which the buyer can exercise the option to buy the underlying stock. For this option, you paid a premium equal to an agreed dollar price per contract. If the price of the share rises above the exercise price, the buyer can exercise his option. If the agreed price is not reached, the buyer can simply let the option lapse.
So how is revenue generated? Daniel Kent, founding partner of Stocktrades.ca, explains: “The ultimate goal when you sell [a call option] is that stock prices stay the same so that not only can you keep the stocks you sold the call option for, but also the premium you received for selling the option, ”explains Kent. “This is how these covered call ETFs offer their investors more income.”
Overall, he thinks covered call ETFs are a good strategy for investors who prefer more income (in the form of dividends and capital gains) over total returns. This could be someone who is retired and who prefers income to growth and wants to finance the expenses. ETFs that offer a covered call option strategy include the Covered Call Canadian Banks ETF (ZWB), the Global High Dividend Covered Call ETF (ZWG), and the US High Dividend Covered Call ETF (ZWH) from BMO. These products use the covered call strategy described above, but each limit it to 50% of the portfolio, so that investors also participate in the market growth. And because they hold dividend-paying investments, these ETFs generate income in two ways: from dividends and from option premiums.