Introduction

In the ever-evolving world of exchange-traded funds (ETFs), fund managers are constantly innovating to attract investor capital. One strategy gaining popularity involves using call and put options to generate what some call “artificial dividends.” This method is particularly common among newer ETFs looking to establish a competitive edge in the market. But how exactly do call and put options work, and are these “dividends” sustainable? Let’s dive into the mechanics, risks, and real-world ETF examples to understand their impact.

Understanding Options Trading

What Are Options?

Options are financial derivatives that give buyers the right—but not the obligation—to buy or sell an underlying asset at a predetermined price (the strike price) before a specific expiration date. Options can be used for speculation, hedging against losses, or generating income.

How Do Call and Put Options Work?

A call option grants the buyer the right to purchase an underlying asset at the strike price. If the asset’s market price exceeds the strike price before expiration, the option gains value. Otherwise, it may expire worthless.

A put option gives the buyer the right to sell an asset at a specified strike price. If the asset’s price drops below the strike price, the option gains value. Otherwise, it may expire worthless.

Example of a Call Option:

If an investor buys a call option on a stock with a strike price of $100, and the stock rises to $110, they can exercise the option to buy at $100 and sell at $110, profiting $10 per share (minus the option premium and fees).

Example of a Put Option:

If an investor buys a put option on a stock with a strike price of $100, and the stock drops to $90, they can exercise the option to sell at $100, securing a $10 per share profit (minus the option premium and fees).

Writing Covered Calls: The Key to Artificial Dividends

One of the most common ways ETFs generate artificial dividends is by writing covered calls. This involves selling call options on stocks that the ETF already owns.

How Covered Calls Generate Income

1. ETF Buys Stocks: The ETF holds a portfolio of stocks.
2. ETF Sells Call Options: The ETF writes (sells) call options on those stocks, collecting premiums from buyers.
3. Income Distribution: The premiums collected are distributed to ETF shareholders as artificial dividends.
4. Potential Stock Sale: If the stock price rises above the strike price, the ETF may have to sell the stock at a fixed price, limiting capital appreciation.

The Importance of Avoiding Volatile Stocks

When selecting ETFs that use covered call strategies, it’s crucial to avoid those that hold highly volatile stocks. If the underlying stock is too volatile, the ETF may generate high dividends in the short term, but this could come at the expense of capital depreciation. If the stock price declines significantly, the “dividends” investors receive could simply be the result of the stock losing value—leading to poor overall returns.

Real-World Example of a Covered Call Strategy

• If an ETF holds shares of Apple (AAPL) at $150 and writes a covered call with a $160 strike price, it collects a premium from the buyer.
• If AAPL stays below $160, the ETF keeps both the stock and the premium.
• If AAPL rises above $160, the ETF must sell at $160, missing out on any gains beyond that.

How ETFs Use Options to Create Artificial Dividends

Instead of distributing dividends from stock holdings, some ETFs generate income through option strategies. Here’s how:

1. Writing Covered Calls: The ETF manager sells call options on the stocks held in the portfolio. This generates premium income but limits the upside potential of the ETF.
2. Writing Cash-Secured Puts: The ETF manager sells put options on stocks the fund is willing to buy. If the stock drops, the fund purchases it at the agreed-upon strike price while collecting premiums.
3. Generating Premium Income: The premiums collected from writing these options add to the ETF’s cash flow.
4. Distributing “Dividends”: This premium income is distributed to shareholders, creating an income stream similar to traditional dividends.

While this strategy provides consistent payouts, it comes with important trade-offs, including potential limits on capital appreciation.

Real-World ETF Examples: U.S. vs. Canadian Markets

To illustrate the impact of option-based dividends, let’s compare ETFs that use options versus those that don’t but hold similar underlying assets.

1. U.S. Market: JEPI vs. SPY vs. XYLD

• JPMorgan Equity Premium Income ETF (JEPI): Uses covered call options to generate monthly income.
• SPDR S&P 500 ETF (SPY): Tracks the S&P 500 without options.
• Global X S&P 500 Covered Call ETF (XYLD): Uses a systematic covered call strategy.

ETF	Dividend Yield	5-Year Return	Expense Ratio
JEPI	~7-9%	~10% annualized	0.35%
SPY	~1.5%	~15% annualized	0.09%
XYLD	~9-11%	~7% annualized	0.60%

• Key Takeaway: JEPI and XYLD deliver high dividends but underperform SPY in total return due to limited upside potential from selling calls.

2. Canadian Market: ZWB vs. XIU vs. HMAX

• BMO Covered Call Canadian Banks ETF (ZWB): Uses covered calls on major Canadian banks.
• iShares S&P/TSX 60 ETF (XIU): Tracks the TSX 60 without options.
• Hamilton Enhanced Multi-Sector Covered Call ETF (HMAX): Uses covered calls and leverage.

ETF	Dividend Yield	5-Year Return	Expense Ratio
ZWB	~6-8%	~7% annualized	0.72%
XIU	~2.5%	~9% annualized	0.18%
HMAX	~13-15%	~N/A (new fund)	0.65%

• Key Takeaway: ZWB and HMAX provide steady income but underperform XIU in total return due to capped upside.

Risks and Considerations

1. Limited Growth Potential

By selling call options, the ETF forfeits some capital gains, which can lead to underperformance in bullish markets.

2. Market Volatility Impact

Option premiums depend on market conditions. High volatility can increase premiums, but prolonged downturns can reduce them.

3. Higher Expense Ratios

Covered-call ETFs often have higher management fees due to the complexity of options trading.

4. Put Option Assignment Risk

When writing puts, if the stock drops significantly, the ETF may be forced to buy at a higher strike price, leading to unrealized losses.

5. Lack of Long-Term Track Record

Many option-based ETFs are relatively new, making it difficult to assess their performance over different market cycles.

Conclusion: Should You Invest in Option-Based ETFs?

Option-based ETFs can be beneficial for income-focused investors, but they come with trade-offs. While they offer high yields, they may underperform growth-oriented ETFs over time. Investors should consider their financial goals and risk tolerance before diving in.

Final Recommendations:

• If you want income: Covered-call and put-writing ETFs like JEPI, XYLD, ZWB, and HMAX are worth considering.
• If you prioritize growth: Traditional ETFs like SPY and XIU may be better long-term choices.
• Always check total return: Dividends are important, but total return (dividends + price appreciation) gives a clearer picture of overall performance.

---

Want more AI-driven finance tips? Subscribe to our blog and stay ahead of the game!

Subscribe Now!

Disclaimer: This blog article is for informational purposes only and should not be considered financial advice. Everyone’s financial situation is unique. Always consult with a qualified financial advisor or planner to assess your individual circumstances before making financial decisions