More Income ETFs from BMO

When Bank of Montreal rolled out ten new ETFs earlier this month, no one should have been surprised that six of them were aimed at income-oriented investors. In my last post, I looked at the four target maturity bond ETFs, and today I’ll pop the hood on the other two. And to reward you for sticking with me to the end of the post, I’ll also give readers a chance to win free tax preparation software from H&R Block.

Let’s start with the least complicated of the new BMO products. The BMO Monthly Income ETF (ZMI) is a portfolio of 10 other high-yield exchange-traded funds, covering real estate investment trusts (REITs), corporate bonds (both investment grade and junk), emerging market bonds, and dividend-paying stocks. In this respect, it’s nothing revolutionary. It’s similar to other ETF wraps like the Claymore Balanced Income CorePortfolio (CBD) and the relaunched iShares Diversified Monthly Income Fund (XTR).

The other new product, however, is unique in Canada: the BMO Covered Call Canadian Banks ETF (ZWB) holds shares in the Big Six banks and sells call options on these stocks to generate additional income. The regular dividends plus the option premiums add up to an impressive yield of more than 8%. But before you’re blinded by that enticing figure, make sure you understand how this ETF works, and the risks involved in the strategy.

What’s a covered call?

First, a refresher on how call options work. Let’s say you own 1,000 shares in Royal Bank, which is currently trading around $55. You don’t think the share price is likely to rise very much over the next few months, so you sell me 10 call options (each contract covers 100 shares) with a strike price of $58 and an expiry date of July 16. The price of these options is 50 cents per share, so you pocket a tidy $500 premium.

Between now and July 16, a couple of things can happen:

  • The share price never reaches the strike price of $58, and my call options expire worthless. I’m out $500 and you get to keep your Royal Bank shares. Even if the price falls from $55 to $54.50 you’d still break even, because your $500 capital loss is offset by the premium you collected from selling (or “writing”) the options.
  • The stock moves above the strike price, and I exercise my option, forcing you to sell me your 1,000 shares for $58 each. You still get a $3,000 capital gain (based on the original price of $55), plus you get to keep my $500. But if the stock price continues to rise, you would have been much better off just hanging on to the original shares.

By writing covered calls, then, you’re giving up much of a stock’s upside potential in exchange for income today. You’re also protecting yourself from small dips in the stock’s price, though a major decline will still hurt you. It’s a strategy that will work well in a go-nowhere market, but it will be disappointing during periods when the market moves higher.

To learn more about the strategy, its risks and potential rewards, see Simon Avery’s excellent article, How covered call options can be a profitable tool, in The Globe and Mail.

An ETF answers the call

Now back to the new BMO fund that uses this strategy. ZWB holds roughly equal amounts of each of the Big Six (for now, at least, half of the fund’s assets are simply invested in the BMO S&P/TSX Equal Weight Banks ETF). The fund will also sell call options on these stocks and distribute the income monthly along with the stocks’ dividends.

One of the biggest risks for individuals using a covered call strategy is that they’re trading against pros. At least with this ETF there’s an experienced manager making the trades: according to the prospectus, the decisions will “depend on market volatility and other factors.” In other words, this is an actively managed fund whose success will depend in large part on the manager’s forecasts. That juicy 8% yield will almost certainly vary greatly over time.

You’re allowed to use covered calls in a registered account, so you can hold this ETF inside your RRSP if you wish. But since RRSP investors aren’t typically concerned about current income, selling covered calls and limiting your upside potential doesn’t make a whole lot of sense. Indeed, for long-term Couch Potato investors, the strategy isn’t appropriate.

On the other hand, if you’re an income-oriented investor using a non-registered account, the argument for using the BMO Covered Call Canadian Banks ETF is stronger. Just make sure you understand the tax consequences. While the dividends from the bank stocks are eligible for the dividend tax credit, the income from the call options is not. In most cases, the Canada Revenue Agency treats option income as capital gains. (However, if the CRA considers you a business investor, it must be reported as income.) As always, talk to a tax specialist before making any major changes to your investment strategy.

Giveaway: H&R Block At Home Tax Software

While we’re on the subject of taxes, I’m pleased to announce another giveaway. H&R Block Canada has offered to give five Canadian Couch Potato readers a free copy of its H&R Block At Home downloadable tax preparation software (retail value $34.99). To enter the draw, Tweet this post, or add a comment below before midnight on Friday, February 18.

39 Responses to More Income ETFs from BMO

  1. AL February 17, 2011 at 7:50 am #

    I so love doing taxes! Sign me up for the software.

  2. Paul G February 17, 2011 at 8:58 am #

    I’m too cheap to spend money on tax software, and I don’t like helping the government by sending things in electronically, but I’d love to give that software a try and see if it’s worth it for future years !

  3. Simon February 17, 2011 at 9:07 am #

    I’ve never used the H&R Block tax software but this would be a good opportunity to try it.

  4. Mark February 17, 2011 at 9:19 am #

    It is not clear from your post: what do you think the tax treatment of the distributions will be? A part of of it will obviously be eligible dividends, but what about the other part, which comes from covered call writing? I am of course wondering about the impact on an individual investor buying this ETF units in a registered account: at some tax brackets the difference between income and capital gains is significant.
    P.S. Not interested in the tax software…

  5. Paula February 17, 2011 at 9:19 am #

    Sounds like BMO is on the ball with new ETF offerings. Would love to have free tax software.

  6. Chris February 17, 2011 at 9:28 am #

    Who loves doing taxes – but I might like it better with this software!

    Tks for a great blog – even when I’m not interested in the funds you’re writing about, I’m just becoming more knowledgeable.

  7. Index Investor February 17, 2011 at 9:31 am #

    This will be the first time I’ll be doing my own taxes so the software will be of great help!

  8. Steve in Oakville February 17, 2011 at 10:45 am #

    I think it’s time to start a blog called “Not Really a Canadian Couch Potato” and include ETFs like this one. The ETF industry is doing exactly what the mutual fund industry did – make products, which are much too expensive and much too complicated, in hopes of catching the next hot thing – in this case, monthly income.

    From the FAQ page on this site:

    “The Couch Potato strategy is a technique for building a diversified, low-maintenance portfolio designed to deliver the same returns as the overall stock and bond markets, minus very small fees. The strategy can reduce a typical investor’s costs by as much as 90%, while at the same time beating the vast majority of mutual funds and professionally managed accounts.”

    I don’t think this new ETF meets the requirements! But alas, I understand the need to inform the public of new ETFs, especially when many will assume that all ETFs follow couch potato basics.

  9. amy February 17, 2011 at 10:45 am #

    I would like to try H&R block tax software

  10. tony February 17, 2011 at 11:20 am #

    Interested in trying H&R block tax

  11. Lyne February 17, 2011 at 11:27 am #

    I’ve never tried this software, thanks for the chance to win 🙂

  12. Hugh February 17, 2011 at 11:36 am #

    I agree with Steve in Oakville. Keep it simple. Keep costs low. Stay on the sidelines where you’ll do less harm to yourself.

  13. Michael February 17, 2011 at 12:14 pm #

    I’d like to try the H&R Block tax software, thanks!

  14. Amir February 17, 2011 at 12:17 pm #

    I don’t like having to pay to file my taxes. The government should provide the tax software free of charge.

  15. Alex February 17, 2011 at 12:46 pm #

    I am in for the tax software! Great blog by the way.

  16. The Dividend Ninja February 17, 2011 at 1:44 pm #

    More importantly, people see the word ETF and think it’s a safe buy. ETF’s are becoming so varied in their risk and goals now, that many of them are on the verge of speculation – and becoming junk bonds themselves. Are investors so hungry for yield they are throwing caution to the wind?

    Remember, when a company launches an ETF are they launching it at the most popular time they think it will sell to the public. Right now its been resource ETF’s, before it was income and inverse income ETF’s, commodity ETF’s, and the list goes on.

    Correct me if I am wrong, but I though the whole point of a Couch Potato, was to build a solid and SAFE portfolio of solid Equity and Bond assets. If you really want to buy these ETF’s (whether they will do well or not) you might as well start active stock picking.

  17. Greg February 17, 2011 at 2:31 pm #

    The ETF industry was not born out of indexing so they are not limited to low cost simple structures. This product is not for everyone and is certainly not for diehard couch potato investors. But, I do think it is of interest to the general readership of this blog. I think it is only a good thing that new low cost products (yes this product has low cost management fees) are coming out on the Canadian market even if they do not fit everyone’s investment strategy.

  18. Kevin February 17, 2011 at 3:02 pm #

    I guess I’m not the only one who loves doing taxes!

  19. Ellie February 17, 2011 at 3:02 pm #

    Count me in!

  20. g sharma February 17, 2011 at 3:33 pm #

    i think market have more downside then upside. and banks are and will be directly and indirectly covered by the Governments. so i do like the ZWB but am not sure this is the right time to enter. then taxation part is not clear as the ETF will do the trading not me but as a part owner depending on the trading profile it may still count as my income even if i never sell (distributions).
    I have been using free StudioTax and would be happy to use H&R Block to see how much better it is.

  21. chantl01 February 17, 2011 at 3:55 pm #

    Thanks for the great education on all the new ETF products out there. I’m learning a lot from your blog. And I’m always interested in trying new income tax software, so please enter me in your draw!

  22. Vincent February 17, 2011 at 3:56 pm #

    I would also like to try the H&R Block tax software. Thanks!

  23. The Dividend Ninja February 17, 2011 at 4:45 pm #

    @Steve in Oakville
    I agree with everything you mentioned – well said.
    @Greg
    Never implied The ETF Industry was born out of indexing. I do agree with you, Dan is providing an excellent service by providing information on a range of ETF’s. I do NOT think it is a good thing that highly speculative or risk laden products such as these are now widely available to average investors.
    @Couch Potato
    This ETF is not appropriate for any Couch Potato – it has much inherent risk. But I’m pleased you are providng information to people on these products.

  24. Mark February 17, 2011 at 5:16 pm #

    Two people from BMO just confirmed, that the covered call premium will be classified as capital gains

    “We have been advised that the premiums received from call writing are classified as capital gains. Thank you for your inquiry and we appreciate your continued support. “

  25. Canadian Couch Potato February 17, 2011 at 5:34 pm #

    Thanks to everyone for their comments. I think I was explicit in saying that an ETF like this one is not appropriate for purely passive long-term investors. One could argue that it isn’t even worth discussing on this blog because it’s not passively managed, but the fact is that many CCP readers are not 100% passive and are interested in new ETFs. I think it’s worth looking at them them and learning more about how they work, even if I have no intention of recommending them in any of my model portfolios.

    @Greg: Actually, the ETF industry was born out of indexing. The first ETF was designed to track the S&P 500, and another very early product (created in 1990!) was designed to track what was then called the TSE 35 (now the S&P/TSX 60). It’s only been in the last several years that ETFs have ventured far from indexing and into active strategies.

    @Ninja: I’m not sure this covered call ETF is particularly risky — at least, it’s really no more risky than BMO’s Equal Weight Banks ETF. It’s highly concentrated in one sector, obviously, so it would have to be a small part of a balanced income portfolio. But a covered call writing strategy actually gives you a little downside protection and is considered fairly conservative. The real risk is that you won’t get as much upside in a rising market.

  26. James February 17, 2011 at 6:17 pm #

    Thanks for the giveaway.

  27. Russ S February 17, 2011 at 6:55 pm #

    As one option contract covers 100 shares, you should change the phrase, “so you sell me 1,000 call options with a strike price of $58” to “so you sell me 10 call options with a strike price of $58.” Those 1,000 options are exercisable on 100,000 shares.

  28. Steve in Oakville February 17, 2011 at 7:29 pm #

    @CCP: I think your readership certainly is more broad than those only interested in traditional passive index investing (take me for instance!), and although it may not be consistent with the underlying mandate of your website, these posts always generate good discussion and allow us to gain new perspectives. That is good stuff.

    I just think it’s interesting to see how the market for ETFs has changed so quickly – 10 years from now, I wonder which ones will still be around?

    I am concerned though about the last point in my previous comment: ETFs are all over the news and get pretty positive press. I wonder if novice investors just assume “ETF” means “diversified, lower cost, beat the majority of mutual funds (and yield 8% to boot!!)”. There was a time this was true, but it’s becoming less and less so…buyer beware I guess.

    @Ninja: I agree with what Dan said about this ETF and risk. Selling covered calls is a very conservate way of trying to squeeze out some extra income, but as Dan pointed out in the post, it comes with the (potential major!?) cost of losing out on upside.

  29. Joe February 17, 2011 at 8:09 pm #

    I’ve always used Tax Turbo or the likes but would surely give H&R Block tax software a shot, I was unfortunate enough to win the giveaway.

  30. Canadian Couch Potato February 17, 2011 at 8:15 pm #

    @Steve: There’s no question that many people (including some in the media) use “ETF investing” and “index investing” as though they were synonymous, even though that hasn’t been the case for years. At least in the case of the covered calls ETF there’s no attempt to market it as passive. Some other ETFs track “actively managed indexes,” which really blurs the line. I will try do my best to make this distinction wherever necessary.

    @Russ: Good point: I made some changes in the post to clarify.

  31. Maxwell February 17, 2011 at 11:53 pm #

    Just posting to put my name in for the potential tax software. I’m running Ubuntu, but I’m sure I could scrounge up a Windoze computer to use it, or emulate it! Anyway, THANK YOU for your blog. I finally have my TD E-series Funds account set up and am in the process of moving $9000 to money market funds so that I can move them into E-Series funds, then sleep on it ^-^. Your site is bloody informative!!!

  32. gibor February 18, 2011 at 12:36 am #

    “But a covered call writing strategy actually gives you a little downside protection and is considered fairly conservative. The real risk is that you won’t get as much upside in a rising market.” – this is the point! I prefer less gain on market upside and less losses on the market downside. Also it’s kinda hedge to more agressive ETFs.
    @CCP “You’re allowed to use covered calls in a registered account, so you can hold this ETF inside your RRSP if you wish”. So I understand that if I’m holding this ETF in my RRSP or TFSA , I don’t have to worry about any “tax consequences. “? Is it correct?
    IMHO , for sake of diverification, I can hold 4-5% of my portfolio in such kinds of ETFs.
    @Maxwell, I have a lot of TD e-funds in RESP accounts, as I don’t want to move them to discount brokerage. Other disadvantage of e-funds that their choice is very limited. For example they don’t have any Small Cap or sectors funds

  33. Em February 18, 2011 at 12:57 am #

    It’s the first year doing my own taxes so tax software would be appreciated. I’ve been nosing around for personal finance guidance and this blog both gets to the point and is easy to understand.

  34. gibor February 18, 2011 at 1:03 am #

    As per BMO “Eligibility RRSP/RRIF/RESP/DPSP/ TFSA ” -!
    Currently I’m looking more at ZMI, CBD, XTR,FIE and CRQ….as I still have money in TD Monthly Income and those 5 ETFs more or less from the same aset allocation class. I want to select couple of those 5 ETFs….

  35. Ben February 18, 2011 at 11:10 am #

    And if one really wants additional yield, one can write covered calls on the ETF as well…

  36. Chris February 18, 2011 at 5:24 pm #

    I’d love to try the tax software! Thanks for running these contests.

  37. George February 18, 2011 at 6:17 pm #

    Count me in!

  38. Open source portfolio February 28, 2011 at 5:10 pm #

    I’ve spent a lot of time trying to figure out how I can utilize options to my advantage. I’ve yet to come up with a decent enough solution. But I’m always left with a feeling that what Derek Foster describes in his book can be used intelligently somehow.

Trackbacks/Pingbacks

  1. The Dividend Ninja » Canadian Covered Call ETFs - November 4, 2011

    […] ZWB was the first covered call ETF introduced in Canada, launched on January 28th by BMO Financial Group. The Canadian Couch Potato covered the launch of ZWB in an earlier post, More Income ETFs from BMO. […]

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