How to Invest in the "Big Six" Canadian Bank Stocks via ETFs, Part 2: Leverage & Covered Calls
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In our previous discussion, we explored a variety of ETFs that provide exposure to the "Big Six" Canadian banks—Royal Bank of Canada (RBC), Toronto-Dominion Bank (TD), Scotiabank (BNS), Bank of Montreal (BMO), Canadian Imperial Bank of Commerce (CIBC), and National Bank of Canada.
These ETFs offered straightforward, long-only exposure, with variations ranging from equal weighting to more complex structures that utilize swaps and corporate class structures for tax efficiency, as well as some that prioritize dividend growth and yield.
However, that first article came with a notable omission: I deliberately left out ETFs that include "enhanced" features such as leverage or covered calls. For those of you seeking higher yields and more intense exposure to Canada’s banking sector, there are specialized ETFs designed to meet these needs.
But be advised, while these enhanced ETFs can offer greater potential returns, they also come with higher costs and increased risk. Here’s my guide.
Leveraged Canadian bank ETFs
In a previous discussion about leveraged ETFs for Canadian investors, we identified two main types:
- Daily Reset Leveraged ETFs: These typically offer 2x the daily returns of a benchmark and achieve this exposure synthetically through swaps. They are designed for short-term trading rather than long-term holding due to their daily reset feature, which can lead to compounding effects that distort long-term performance expectations.
- Longer-Term Leveraged ETFs: Unlike their daily reset counterparts, these ETFs do not use swaps but instead employ actual borrowing, similar to using a margin account. The leverage is usually more conservative, around 1.25x.
In the market of Canadian bank ETFs, there are two competing products, each aligning with one of the leveraged types mentioned above:
The first is the BetaPro Equal Weight Canadian Bank 2x Daily Bull ETF (HBKU), managed by Global X ETFs (formerly Horizons ETFs). This ETF uses swaps to deliver daily 2x performance relative to the Solactive Equal Weight Canada Banks Index.
It comes with a high management expense ratio (MER) of 1.84% and is primarily suited for those looking to speculate on short-term movements in the banking sector if bullish.
The use of daily resetting leveraged positions makes it unsuitable for long-term holding as the compounding effect can lead to performance that deviates significantly from 2x the index's movement over extended periods.
For those considering a more long-term approach, the Hamilton Enhanced Canadian Bank ETF (HCAL) presents a viable alternative. This ETF employs cash leverage by borrowing 25% of its net asset value to invest directly in the banks represented by the Solactive Equal Weight Canada Banks Index.
This method mirrors what an investor might do by opening a margin account and investing in the big six banks, but with access to more favorable institutional borrowing rates. HCAL has proven quite popular, boasting $585 million in assets under management and offering a 6.39% yield with monthly distributions.
Though the MER is relatively high at 2.16% as of the latest ETF Facts document from June 5th, it's important to note that this figure includes the cost of borrowing for leverage. The actual management fee within this total is only 0.65%. As interest rates decline, we can expect the next update to the MER to reflect lower costs.
Covered call Canadian bank ETFs
Covered call ETFs present a lower-risk, income-oriented alternative to the capital growth-focused leveraged bank ETFs. Essentially, covered calls allow investors to generate income while potentially reducing risk, but at the cost of capping the upside potential of their investments.
These ETFs operate by holding shares of bank stocks and selling call options on them, which are termed "covered" because the ETF owns the underlying shares, unlike "naked" calls which involve selling calls on shares not held by the seller.
The payoff profile for covered call ETFs involves sacrificing potential upside price appreciation in exchange for income derived from option premiums. The size of these premiums is influenced by factors such as the moneyness of the option, theta (time decay), and the volatility of the underlying stock.
In different market conditions, covered call ETFs will perform variably:
- Sideways markets: They tend to outperform as the stock prices do not rise above the strike price of the calls by expiry, allowing the ETF to retain the premium without sacrificing capital gains.
- Bear markets: These ETFs provide a cushion through the premium income, which can offset some capital losses but is not a true hedge.
- Bull markets: They lag behind because the call options cap the upside, meaning that gains from the underlying stock are limited past the strike price.
Two notable ETFs in this category include the Global X Equal Weight Canadian Bank Covered Call ETF (BKCC) and the Hamilton Canadian Financials YIELD MAXIMIZER ETF (HFIN).
BKCC uses a dynamic covered call writing strategy where managers actively select the proportion of the portfolio to cover, along with the strike prices and expiries. This approach trades upside potential for enhanced income, resulting in muted price movements but a high annualized distribution yield of 12.31%, with monthly payouts. The MER sits at 0.57%.
On the other hand, HFIN includes not only the big six banks but also life insurance companies and asset managers like Manulife, Intact, Sunlife, and Brookfield Corp. It employs a strategy of selling at-the-money covered calls on up to 50% of the portfolio. HFIN currently pays a 14.16% distribution yield with monthly payouts.
Leveraged covered call Canadian bank ETFs
Finally, we examine the riskiest category within this sector: leveraged covered call ETFs, a new invention in the ETF industry and one unique to the Canadian market.
Recall that the main drawback of traditional covered call strategies is their muted upside potential. During bull markets, the strike prices of sold calls can be breached, and shares may be called away below their current market prices, resulting in lost upside.
To address this, some newer ETFs therefore employ leverage to enhance potential returns. A prime example is the Global X Enhanced Equal Weight Canadian Banks Covered Call ETF (BKCL), which uses cash leverage to potentially amplify both yield and upside.
Here’s how it operates: BKCL invests in BKCC by borrowing an additional 25% of its net asset value (NAV) through a margin loan. This strategy allows BKCL to own 125% worth of BKCC, creating an efficient way to leverage the underlying ETF’s assets.
With this leverage, both the potential yield and upside are magnified, but it's important to remember that the downside is also increased. This ETF has not yet been tested in a bear market, and in a banking crisis, the 1.25x exposure to just six banks could lead to significant drawdowns.
However, if you can manage the associated risks, BKCL currently offers a 14.99% annualized distribution yield with monthly payouts. Keep in mind, the MER is relatively high at 2.59%, but this includes the cost of borrowing.
