BMO launched its Covered Call Canadian Banks ETF (TSX: ZWB) in January 2011. The ETF immediately started attracting investor attraction. Investors were mesmerized by the initial annualized yield of 10% and piled money into the fund: among ETFs launched in 2011, ZWB ranked first by Assets under Management by a wide margin. Interestingly, the second most popular among ETFs launched in 2011 is another covered call product: the Horizons Enhanced Income Equity ETF (TSX: HEX). Investors had clearly developed a preference for income products.

It appears that many investors thought (or at least hoped) the higher yield from ZWB compared to a plain vanilla product like the BMO S&P/TSX Equal Weight Banks Index ETF (TSX: ZEB) would translate into higher total returns. Now that ZWB has a 2 year track record under its belt, we can analyze how ZWB’s returns stacks up against ZEB’s.

Performance for the 2-year period ending Jan. 31, 2013

BMO Covered Call Canadian Banks ETF (ZWB): 8.10%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 8.92%

We find that the Covered Call ETF under performs the Bank ETF by an annualized 0.82 percent over a two year period even though it is just 0.10 percent more expensive than the plain-vanilla ETF. In the following graphic, we break down the total returns from the two ETFs into income and capital gains.

Comparing returns from ZWB and ZEB

The one year performance (for the period ending Jan. 31) of the Covered Call Banks ETF (ZWB) is compared with that of the Equal Weight Banks ETF (ZEB) in the following table:

ZWB ZEB
2012 2.84% 3.59%
2013 14.01% 14.52%

If we look at the income generated by these two ETFs as a percentage of starting NAV, we get:

Income generated for the 1-year period ending Jan. 31, 2012

BMO Covered Call Canadian Banks ETF (ZWB): 9.2%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 3.5%

Income generated for the 1-year period ending Jan. 31, 2013

BMO Covered Call Canadian Banks ETF (ZWB): 6.8%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 3.6%

In other words, though an investor earned a significantly higher current income with ZWB, she would have earned lower total returns compared to an investment in ZEB over the past two years. Also, the income an investor receives from the covered call ETF has been dropping: the fund started off with an annualized yield of 10 percent but two years later, the yield is just 5.6 percent. Granted, a two year time frame is too short to make a fair comparison of ZWB and ZEB but the early results show that just as we initially suspected, there is no free lunch here.

NB: This post was initially published on Feb 20, 2012. It was updated on Feb 5, 2013.

This article has 27 comments

  1. I’m not sure how useful it is to compare total return alone, since it’s expected that a covered call strategy will have a lower total return but also a lower beta. It would be more useful to compare the risk-adjusted return. Are there any good websites that let you easily compute the Sharpe ratio for Canadian ETFs?

    • A simple month by month over the year shows clearly ZEB did better in a rising market and worsen more than ZWB in a correction. This is exactly what the pair offer and should do. It is comforting that in the end, both are comparable. It is a pity that only covered calls are done and short puts are excluded in the offer.

  2. Any insights on the reason for the lower performance of ZWB?

  3. A small minority of investors may be hoping for better risk-adjusted returns (like Viscount), but I suspect that most investors dream of higher returns and lower risks. Unfortunately, there are no perpetual motion machines, and there are no derivative-based perpetual profit machines.

  4. @Viscount: When these products launched, covered call ETF sellers implied that the strategy can be expected to deliver as good or better returns than traditional passive strategies with lower risk. The lower risk part is not exactly desirable in the case of covered calls because an investor is giving up the upside volatility but at least some studies showed covered call strategies performing as well as passive strategies. It would be interesting to compare ZWB with ZEB for future years to see how the returns compare.

    @Michael: I can think of a couple of reasons: (1) ZWB has higher management fees. (2) ZWB likely incurs higher trading costs because the fund is regularly buying and selling options.

    @Michael James: From what I hear, investors were attracted to these funds for their high yield. They are once again forgetting that while distributions are nice, it is total returns that really matter.

  5. @Viscount: To add to my comment, Sharpe ratio may not be a good measure of the risk of covered call ETFs because the distribution of returns is not normal. (i.e. the fat tails on the right side of the distributions are truncated).

  6. To be fair, 2011 was not the kind of year that would have lead to outperformance by a covered call ETF, so the sample might be too small to conclude that the fund will always underperform.

  7. I’m glad I didn’t bite into the hype. It sounded so good when the ETF was launched!

    So how is that 9% “income” taxed? ROC? Interest? CG? Dividends?

  8. BuT if you were to reinvest the income flow. Then what would the compound return comparatives be? Also ZWB isn’t fully invested holding some cash in reserve

  9. As to tax for canadian based corrporations the taxes would be dividend and capital gains. Also for those living on fixed income and income flow to meet bills a higher yield would be welcomed although the yield has been variable but still better than interest rates currently and better tax incentives for the average investor doing options such as coered calls would have been beyond their scope until te new etfs. Time will give a better reading

  10. @Andrew: I think 1 year is a very short time to evaluate an investment strategy but I would have thought a covered call strategy would have outperformed last year because volatility was very high.

    @Sean: The tax information is not available yet but my understanding is that ZWB’s distributions will be a mixture of dividends and capital gains.

    @bev: The returns reported here assume that the distributions were reinvested.If you look at change in value plus distributions, ZWB returned 1.43% over the 1 year period ending Jan. 31, 2012. ZEB returned 2.35% during the same time period.

    • canadian capitalist your theory that covered calls should work best in a volatile market is wrong. might want to dust off a few textbooks.

  11. Just to confirm the total returns posted above for ZWB and ZEB include the distribution of the two particular ETFs correct?

  12. I’m thinking of launching a new investment product named Punk’d. It would yield 20% and be completely tax efficient(ROC).

    I’m wondering how many suckers would buy this great yielding product and how long it would take before they realized they were being punked and only getting their own money back.

    What a world we live in. Capital can’t be sold to meet spending needs but distributions, well of course those can be spent. Nevermind their sustainability, mental accounting at its finest.

    • @gsp: The new investment product will be very successful. After all, covered calls aren’t the only products making ROC distributions. Many other income products do the same thing and are in heavy demand with investors. How soon the lessons of income trusts have been forgotten!

  13. Sometimes I think this wouldn’t be as bad of an investment with the use of tax-free or deferred accounts.

    As long as they are open-ended and people keep piling money into them (e.g. monthly income funds), then who cares if it is ROC, interest, cap-gains, or whatever form the distribution takes. As long as there is some price stability in the underlying holdings, then the distribution becomes sustainable from new money.

    A legal Ponzi scheme if I ever saw one.

    • @Sampson: I agree that covered call ETFs aren’t that bad when held in tax deferred accounts or even when an investor needs the income. I was skeptical about claims made when these ETFs first came out that covered calls can earn alpha. It doesn’t seem to be the case, albeit based on a very short history.

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  16. if I invested 10000$ in zwb in Jan 11 I would have 11204$ in my account in Jan 12.
    if I invested 10000$ in zeb in Jan 11 i would have 10709$ in my account in Jan 12.
    How can you say zwb was worse than zeb???

  17. @Millionaire: I’m not sure where you got your numbers. Over the year, ZWB dropped from about $15 to about $14 while paying about $1.40 in dividends. That won’t get you from $10,000 to $11,204.

  18. One year is definitely too short a time frame for a valid comparison. If you look at the Kapadia and Szado study on the Russell 2000 for example, they used a 15 year period.

  19. The covered call strategy is a bearish strategy which sells stock price upside in exchange for a premium. Since the underlying ZEB went almost exactly nowhere in 2011, this should have been a decent idea that paid off nicely. I think the active management of the call writing by BMO bungled what should have been the perfect year for bank call writing, a trendless volatile market that went down a little.

  20. zwb has treated me very well. I see it as an income turbocharger as we all hold the canadian banks in the xiu’s of the world. It helps reduce the volatility in my portfolio with lots of income to reinvest. I have capital gains and nice income. Love zwb…

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