BMO launches equity income-maximising ETFs

BMO Enhanced Income UK Equity UCITS ETF (ZWUK), BMO Enhanced Income Euro Equity UCITS ETF (ZWEU) and BMO Enhanced Income USA Equity UCITS ETF (ZWUS) replicate the popular income-boosting strategies employed by active funds such as Schroder Income Maximiser and Fidelity Enhanced Income, but at a lower cost – they have an ongoing charge of 0.3 per cent. However, the ETFs aim to deliver similar returns to the indices they track with a higher income and lower volatility, rather than outperform them like active funds.

BMO Enhanced Income UK Equity and BMO Enhanced Income Euro Equity will have an expected total gross yield of about 7 per cent, and BMO Enhanced Income USA Equity will have one of about 5 per cent.

The ETFs generate their extra income by selling call options on the indices they track. Buyers of BMO's index options pay the ETFs a premium for the right to acquire stocks they hold at slightly higher than the current price. This is known as a covered call strategy and means that when these stocks reach the agreed price the ETFs must be prepared to sell them to the acquirer, and take profits. In return the ETFs receive a steady income stream on top of any income derived from their underlying holdings.

Investors in these types of funds can receive market-beating yields from the stocks that make up the mainstream indices. The steady income stream the ETFs will receive means they are likely to be less volatile than mainstream indices, and when markets are falling they should hold up better than mainstream index trackers.

Another advantage is that the income generated by these ETFs will not come at the expense of capital growth. A major drawback of higher-yielding equity income ETFs is that the shares they track pay out too much of their income as dividends and cannot divert as much capital to future growth. But covered call ETFs hold the same stocks as mainstream indices and their income is not wholly dependent on dividends.

These ETFs should be particularly useful in flat or falling markets, as the income boost protects their investors from losing the same amount as the broader index.

But these ETFs will not outperform a broad market ETF in total return terms when markets are rising. Just as covered call ETFs do not feel the full brunt of a market downturn, they also do not partake in full market rallies because they have to sell out of stocks when they reach their agreed option price, known as the strike price.

Oliver Smith, portfolio manager at IG, says: "This [covered call] strategy means that you receive an immediate income boost but the upside is capped and determined by the option strike price. It works well compared with a regular stock index if you think markets will trend sideways or be weak, and from that perspective could be interesting for investors."

In recent years, benchmarks such as the FTSE 100 and S&P 500 have trended sharply upwards, so an investor seeking total returns would have been better off with a low-cost mainstream equity index ETF, rather than one using a covered call strategy.

Over the 10 years to 18 July 2017 the S&P 500 covered call index delivered a total return of 68.2 per cent in contrast to the S&P 500 index's 106.4 per cent return. In this case a higher income would not have been enough to replicate the dramatic capital growth of the S&P 500.

However, Mr Smith says: "Markets are not hard-wired to go up in a straight line so the next 10 years could show us something different if markets go through periods of volatility."

ETFs using covered call strategies could generate higher implicit costs because they have to trade more than mainstream ETFs. But Christine Cantrell, UK ETF sales director at BMO, says because these ETFs sell index options rather than stock options it reduces the trading volume. It also means the spreads these ETFs pay on the options are lower.

And BMO's large size in Canada, where it already runs a number of covered call ETFs, means dealing costs should be lower.

BMO's UK listed enhanced Income ETFs

Source: BMO & *Thomson Datastream