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Finance 101

Alternative Strategy ETFs Part 1: Covered Calls

March 4, 2015

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Alternative Strategy ETFs Part 1: Covered Calls

Finance 101

This is the first in a series on Alternative ETFs.

What are alternative investments?

Alternative strategies are investments that differ from traditional buying and selling of stocks and bonds. They typically use derivatives, futures, options, leverage, arbitrage or short-selling. Using these products, they can generate absolute returns that are independent of an index or benchmark over a defined period of time.

There is a broad spectrum of alternative products, which include hedge funds, private equity, managed futures, structured products, mortgage, and private lending.

WealthBar uses alternative investments in a limited way to create a more diversified portfolio. We find including certain alternative ETFs can significantly reduce the market risk within the portfolios whilst stabilizing returns and boosting cash flow.

Alternative ETFs

While typically alternative strategy funds are hard to access, illiquid, require large minimum investments, and charge high fees, a growing number of alternative strategies are now accessible through low-cost exchange-traded funds (ETFs). These ETFs typically use various derivative or hedging strategies to achieve their objectives, including covered calls, volatility, hedge strategies, commodities and managed futures.

Covered call strategies decrease the risk of stock ownership while providing additional income.

Volatility strategies hedge against stock market declines which historically tend to coincide with periods of high market volatility.

Commodities through investment in the physical commodity or managed futures trading contracts in areas such as metals, grains, equity indexes, soft commodities as well as foreign currency and government bond futures.

Hedge strategies target market returns but aim to achieve this with either substantially lower market risk or higher positive absolute returns. This is often achieved by investing in a way that reduces their correlation with the market, however, the term “hedge fund” has come to encompass a broad range of different investment strategies.

Canadians have a growing choice of alternative ETFs from providers that include iShares, BMO, First Asset, Horizons, and Purpose.

Advantages of Alternative ETFs

Gaining exposure to alternative strategies through ETFs offers several advantages, particularly when compared with mutual and hedge funds.

Alternative ETFs are liquid because they trade on stock exchanges and can be purchased or sold throughout the day. This is unlike mutual or hedge funds which may have a notice period as long as 3 months and can even cap or limit redemptions altogether.

Management fees for ETFs are typically less than 1% even for alternative strategies. Hedge funds management fees are typically 2% plus 20% of any performance gains above a specified watermark;

ETFs are also transparent with their holdings and strategies.

In this series on Alternative ETFs, I will explore some the different alternative strategy ETFs available to Canadians in detail.

Covered Call ETFs

There are many Covered Call ETFs available in Canada, covering broad markets and specific sectors. A covered call strategy helps to decrease the risk of stock ownership while providing a higher yield.

How Do Covered Calls Work

Covered calls involve buying a stock and writing (“selling”) a call option against it.
An option is a contract that gives the holder the option (or right) to buy or sell an underlying interest in a stock at a specified price (“strike price”), within a specified period of time (“expiration”). By writing a call against an underlying position, the investor receives a premium but at the risk of being required to sell the stock at a lower price if the price exceeds the strike price before it expires. The covered call writer foregoes some amount of potential upside but in return receives a guaranteed option premium.

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Covered Call Benefits:
* Cash flow through the writing of option premiums
* Reduced volatility over just holding the stocks
* Limited downside protection by receiving the call premium if stock prices decline slightly
* Stock owner continues to receive the benefits of stock ownership such as the dividends
* Tax-advantaged income as both dividends and call premiums are taxed at lower rates than interest income

Covered Call Disadvantages:
* Under performance if there is a large appreciation of the asset
* Returns will still be subject to market declines (though slightly less than just holding the stock)
* Requires a more active strategy than just buying and holding an index

Obviously, the goal with a covered call strategy is to hold stocks that have short-term price volatility but are expected to gradually trend positive over the long term. The implied price volatility increases the value of the options being sold. Also, it is ideal if they pay good dividends. Generally, it will be stable, profitable companies that pay dividends are well suited for a covered call strategy.

WealthBar uses the BMO Dow Jones Industrial Average (DJIA) ETF – ZLB

With the range of covered call ETFs available we selected the BMO DJIA ETF (“BMO ETF”) because we wanted broad market US equity exposure with lower volatility and cash flow. The US security and options market is far more liquid than the Canadian market, making this strategy more efficient.

For BMO ETF the calls are written proportionally to the security weights of the Dow Jones Industrial Average. The written percentage of the portfolio is consistent across securities.

Depending on market conditions, out of the money (“OTM”) options are sold on at least 50% of the portfolio. This enhances yield and participation in rising markets. BMO ETF selects the option’s strike price depending on the implied volatility of the option and general economic conditions.

When volatility rises, the option’s value increase in price. The BMO ETF will then sell calls further OTM while maintaining the desired level of call premiums and they will sell closer to the money when volatility drops as there is less potential for significant short-term price appreciation.

The BMO ETF’s dynamic selection process allows for further upside participation in volatile markets.

The closer that options are to expiry, the greater time decay they experience, which benefits option writers. The BMO ETF sell options 1 to 2 months from expiry in order to take maximum advantage of time decay. These options are generally held until expiry.

The BMO ETF provide long-term risk-adjusted returns, along with a tax-advantaged income stream. The strategy writes short-dated, OTM options and uses a dynamic selection process allows for further upside participation in volatile markets. Investors benefit from the broad US market exposure and an enhanced yield from dividends and option premiums.

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