High Yielding Low Volatility ETFs
By: Andres Rincon
June 16, 2022 - 4 Minutes
2022 has been challenging for most asset classes. Equity markets have experienced major pullbacks since the beginning of the year while fixed income markets have delivered an overall poor performance due to rising rates. In the current environment of lower returns, higher volatility and high inflation, many investors are turning to investment products that offer low volatility but also higher yields to offset some of today's challenges.
Given that CPI in Canada has been consistently above 5% during 2022, only products yielding above this level are able to maintain purchasing power for the investor. However, the challenge lies in finding high yield without significantly going up the risk curve. Adding more volatility or poor credit to a portfolio is unlikely to add value today solely to achieve a yield goal. The need for yield in this case needs to balance between volatility and yield.
Given that CPI in Canada has been consistently above 5% during 2022, only products yielding above this level are able to maintain purchasing power for the investor. However, the challenge lies in finding high yield without significantly going up the risk curve. Adding more volatility or poor credit to a portfolio is unlikely to add value today solely to achieve a yield goal. The need for yield in this case needs to balance between volatility and yield.
Enhanced Yield ETFs
Enhanced Yield ETFs, which encompass Covered Call ETFs, Put Write ETFs, or a combination of both strategies, may offer a higher yield than a typical equity portfolio through writing vanilla options on individual securities or a broad market benchmark. They may be particularly attractive as means of obtaining higher yields and reduced volatility in a low interest rate, higher volatility, or low-growth environment.
Why Enhanced Yield ETFs?
In a low interest rate, high volatility, low earnings growth environment, income-oriented investors may consider alternative investment strategies to generate higher yields. Covered Call ETFs, which supplement dividends from the underlying securities with an options overlay may produce higher yields and tend to be slightly less volatile compared to similar portfolios that only hold the underlying stocks. Covered Call ETFs generally offer a monthly distribution and span across a wide range of exposures, including ETFs that provide exposure to a broad market or a particular sector.
In selecting a Covered Call ETF, consider the following:
In selecting a Put Write ETF, below are some important considerations:
In selecting a Covered Call ETF, consider the following:
- Underlying Portfolio: What are the underlying securities held within the ETF and is this exposure a good fit in the context of the overall portfolio?
- Investment Objective: Is the fund's primary objective to achieve a high stable yield over the long run or to maximize risk-adjusted returns by using options opportunistically?
- Systematic vs. Discretionary Approach: Does the ETF generally write call options on all the underlying securities or only some of the names? If only some, how does the portfolio manager determine which ones to write options on?
- Maximum and Average % Covered: Is there significant variation in the % covered ratio for each underlying security or is it generally consistent across the portfolio? What are some factors driving the variation in the coverage ratio?
- Options Strategy: How does the portfolio manager think about factors that impact option pricing?
In selecting a Put Write ETF, below are some important considerations:
- Security Selection: How does the portfolio manager determine which securities it would like to write put options on?
- Options Strategy: How does the portfolio manager determine which put options it would like to sell (i.e., what is the target yield, how are strike prices and expiries determined)? What is the strategy for the underlying security if the put option is exercised and stock is delivered? How long is the ETF willing to hold the underlying stock for?
- Track Record: Does the manager have a good track record in generating excess risk-adjusted returns through its combination of security selection, market timing, and options strategy?
- Cash Management: As the portfolio largely consists of cash, its cash management practices may have a meaningful impact on the ETF's overall yield. Is the cash being deployed in the most efficient manner possible?
Boosted ETFs also play a big role in growth this year
Boosted ETFs offer a boosted return and yield in a low yielding environment by borrowing cash from a prime broker to purchase 25% more of the assets underlying the basket. Yields on boosted ETFs may be considerably higher than 5%. The prime broker will take the underlying assets of the boosted ETF as collateral to lend out cash to the fund. This mechanism is a common practice with hedge funds, which often borrow multiples of the value of the underlying assets. Boosted ETFs only engage in leverage to a very small scale so far. The boosted ETF will then deploy the borrowed cash into more units of the underlying ETF or underlying securities it holds. The name of the game for these ETFs is yield. In a low rates and yield environment, the ability of issuers to create products that offer negligibly higher volatility whilst providing above average yields is what will continue to drive creativity and launches in Canada.
Director and Head of ETF Sales & Strategy, TD Securities
Director and Head of ETF Sales & Strategy, TD Securities
Director and Head of ETF Sales & Strategy, TD Securities