First things’ first: How do Covered Cap funds work? A covered cap fund takes advantage of mutual fund rules that allow a mutual fund or ETF to hold a limited percentage of its assets in derivatives, in order to hedge returns. Covered Cap funds take advantage of these rules to create hedged positions that generate returns. In general, this is accomplished by buying equity in a diversified portfolio of well-established competitors in a given industry, and then strategically selling monthly call-contracts on the positions to create an income stream from the portfolio.
In general, the end result is a fund that will generate about a 10% yield on a relatively inexpensive overall purchase for the investor. This purchase winds up creating additional value for the investor in the way that it provides the investor with access to the derivatives expertise required to best price out the value of the contracts to sold (thus maximizing yield), while diversifying the returns throughout a portfolio. Sound confusing? Let me give you an example from one of the pioneers of this strategy.
The Bank of Montreal Diversified Financials Covered Cap ETF (ZWB) hold a diversified portfolio of (mostly Canadian) banks, and then proceeds to strategically sell call contracts on a percentage of its holdings to increase the yield of these stocks to between 8-12%, paying out monthly. While the market price of the ETF itself is still relatively volatile due to its nature as a fairly new issuance, its exchange traded nature allows investors the opportunity to further hedge out the implications of volatility in the NAV through further options strategies (see the previous articles of this week).
Regardless, an investor with a longer time horizon should have no difficulty in justifying this kind of yield, as the position pays itself off through dividends alone in 10 years. This is the equivalent of owning a share of a diversified portfolio of monster-cap banks with more than 3 times the dividend rate.
Let’s look at another more relevant example. Horizon ETFs Enhanced Gold Producers Income ETF (HEP) addresses the complaints of most gold-bugs, in that their gold production companies insist on avoiding dividends, even though their margins and cash flows have increases dramatically with the rapidly rising price of gold.
The solution? Horizon ETFs builds a diversified portfolio of gold producing stocks, and provides a yield to investors through the strategic sale of calls. This gives an investor exposure to their favourite gold producers, but with the added benefit of a yield, an excellent combination. But what’s the catch?
Although Covered Cap funds provide a fantastic fixed-income opportunity for smaller investors, it is important to understand that there are some very serious implications associated with their usage. In my next article, I’ll explain just how complex the risks associated with this kind of investment are, and what level of sophistication an investor needs to maintain when dealing with them.
Note: At the time of writing this article, I have no positions in either HEP or ZWB, and does not intend on entering any in the next week.