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.