Patrick Sommerville breaks down the category, how it’s fit in options ETFs, and the role of a bull market in
In July of 2021 Hamilton ETFs launched HDIV, an ETF holding a portfolio of the firm’s other covered call option ETFs and applying what it calls “modest” leverage of 25 per cent. In the five years since that ETF has accrued over $1.7 billion in assets. Today there are 27 Canadian-listed ETFs combining leverage and covered call option strategies from six ETF issuers, holding roughly $8.9 billion in assets, according to data from the Canadian ETF Association. While the levels of leverage, underlying holdings, and specific options strategies vary widely between these ETFs, the emergence of the category as a popular allocation could be illustrative of wider investor appetites.
Patrick Sommerville, co-CEO of Hamilton ETFs, broke down the underlying strategy that he believes made his and other firms’ leveraged call option ETFs so popular. He outlined why his firm sees 25 per cent as the “sweet spot” for leverage and how that has dovetailed with covered call options. He explained how he sees the role of a bull market fitting into investor appetites and how he tries to protect against the way leverage can amplify the downside as much as the upside in a portfolio.
“To us, 25 per cent is what we would say is like the Goldilocks amount of leverage. It’s not enough to severely impair capital, but it’s enough to help you over the long term and just compound your returns over the long time, assuming it’s a long-term investor, and also assuming that the underlying holdings are conservative in nature,” Sommerville says. “It doesn’t make sense for every sector or every underlying type of holding. In our view, you want to make sure that it’s a conservative blue-chip underlying. Particularly because leverage can work two ways. It can help you but can also work against you in falling markets.”
Who’s buying leveraged options ETFs?
Sommerville explains that his firm noticed the market for covered call ETFs in the wake of the COVID-19 pandemic. Originally a financial sector specialist firm, they saw the Canadian banks as attractively priced and noticed that many of the advisors they worked with had an appetite for income. Once their covered call products had gained some traction, they looked for ways to improve on the issue that all covered call strategies have: they cap upside potential in exchange for income. The addition of 25 per cent leverage, Sommerville says, allowed Hamilton to add to the ETFs’ yield while mitigating some of that capped upside.
These products, he says, have timed well with the mass retirement of the baby boomer generation. A larger per centage of investors are looking for retirement income, and they’re attracted to the tax efficiency of covered call options as their income is paid as capital gains. Sommerville says that in his firm’s experience, there has been a balance between the advisor and DIY channels in terms of their appetites for these ETFs. Where that interest starts to diverge, Sommerville says, is when we look at ETFs with yields in the low 20s. Those ETFs, which tend to come with higher levels of leverage or more volatile or concentrated underlying holdings, tend to be more popular among DIY investors.
The role of a bull market
Sommerville acknowledges that these ETFs have benefitted from strong bull markets, which has likely buoyed their popularity. With the exception of 2022, annualized returns on US and Canadian equity markets have been incredibly strong since HDIV was first launched. That strength has meant the leverage has worked and many of these products have seen significant NAV growth in addition to their income payouts. Moreover, the market dips and corrections that have taken place over the past half-decade have tended to be followed by sharp moves upwards.
“I think investors have been trained to buy the dip since COVID,” Sommerville says.
Despite this strong performance, ongoing investor confidence, and narratives around market backstops like the Fed put, Sommerville acknowledges that this bull market could still end and markets could move in the other direction. When that happens, the leverage in these ETFs will accelerate the downside just as it contributed to the upside. Sommerville argues that this dynamic makes the underlying holdings of a leveraged ETF essential to understand. He says that blue-chip companies held in diversified baskets should be able to better withstand a market downturn.
For advisors now looking at this category of ETFs, Sommerville says that there are host of criteria to assess them on. Past performance may only tell so much. He believes that underlying holdings, leverage levels, and call option strategies all need to be understood. He also stresses an assessment of the management team’s depth and strength, especially in the execution of options strategies. All of these criteria need to be made clear when advisors work to outline these strategies.
“The key communication is appropriately talking about the long-term opportunity, but also appropriately talking about and bringing forth the risks inherent by adding a bit of leverage,” Sommerville says. “Ultimately, I think for advisors who are trying to increase the yield in their clients’ portfolios, these are very, very good tools as a piece of the pie. They’re not meant to be, a huge chunk of the pie. They’re meant to be a small percentage to help people realize higher, tax-efficient yield.”
