Crypto Covered Call ETFs

By Markdale Alternatives, Funds, Investing #alternativeinvesting, #blockchain, #fintech, #options, cryptocurrency 1 Comment

In today’s low rate environment, yield hungry investors are adding more covered call ETFs to their portfolios. ETF issuers now offer a variety of interesting products, and recently, Purpose Investments began offering two covered call ETFs based on cryptocurrencies. Because of the high volatility of cryptocurrencies, these ETFs offer huge yields compared to other covered call ETFs based on stocks.

This post describes the current market for cryptocurrency ETFs, covered call ETFs, and then considers two cryptocurrency covered call ETFs offered by Purpose Investments: Bitcoin Yield ETF and Ether Yield ETF.

Bitcoin & Ether ETFs

With the prohibition of crypto ETFs in the United States, Canadian markets have been flooded with new issuers in the past year. Investors now have a variety of crypto currency ETFs to choose from, including:

Investors should expect to pay around 1% per year for most of these crypto ETFs. This might be a good deal or a bad deal depending on your investment objectives.

Regardless of whether using cryptocurrency ETFs is right for you, cryptocurrency ETFs have created a new way for investors to trade and hold cryptocurrency through regulated public markets. This might be a boon for investors uncomfortable with the technical and tax aspects of holding cryptocurrency directly. But, these cryptocurrency ETFs might not be suitable for investors who value cryptocurrency for use as a medium of exchange or because blockchains exist outside government control.

Purpose Investments has created two ETFs that use cryptocurrency ETFs as a base; then they layer on a covered call option strategy to generate additional income for investors. The income investors receive from this strategy is very high, as this post will further explain.

What is a Covered Call?

Before diving into the specifics of the new cryptocurrency covered call ETFs, its important to understand what a covered call is. Understanding what covered call is will enable investors to better grasp the risks covered call ETFs present.

A call option gives the buyer the right to purchase an underlying security at a specific price in exchange for making a premium payment. The call option seller (or “writer”) receives a premium payment from the buyer in exchange for having the obligation to sell an underlying security at a specific price in the future.

This trade-off leaves the call option buyer with unlimited upside but leaves the option seller with unlimited downside. A “covered call” option strategy is where the option seller owns the underlying security the call option is sold on, thereby limiting the downside risk.

covered call graph — Image by Julie Bang © Investopedia 2019

Covered call option strategies generate additional income for the call option seller in exchange for capping their upside. For example, an investor may own 100 shares of RBC and then sell call options against those shares, receiving a cash payment in exchange. The investor has capped the benefits they may receive from the gain in the value of their RBC shares, but in exchange they receive additional income.

Covered call strategies are most appealing during times of high volatility, sideways and down markets. This is because the premiums investors receive for selling call options reduces their risk by providing income in return.

What determines the value of an option?

The value of an option is partly determined by the volatility of the underlying instrument. Options for stocks that are highly volatile will have higher premiums compared to options for stocks with low volatility. This makes using a covered call strategy particularly appealing for cryptocurrency investors since the volatility of cryptocurrencies is so high.

The volatility of bitcoin and Ethereum are high relative to stocks and other investments. Therefore, the income generated from a covered call strategy with cryptocurrencies generates higher income too.

Covered Call ETFs

There are many covered call ETFs available to Canadian investors today. Major issuers include BMO, Horizons, and CI Investments. Each of these issuers offers a variety of covered call strategies targeting broad markets and specific sectors.

Investors should expect to pay a little bit more for a covered call ETF compared to a plain vanilla ETF based on a broad market index such as the S&P/TSX 60 or the S&P 500 Index. These ETFs typically charge MERs in the range of 0.70% per year in Canada today.

In exchange for this fee, investors receive much higher income from covered call ETFs than they do merely holding shares in the underlying stocks themselves. At a time when the S&P/TSX 60 is yielding 2.50% from dividends, many covered call ETFs have distribution yields of 6% to 8%. These higher yields are why covered call ETFs seem attractive to yield hungry investors.

Investors in covered call ETFs can choose from sector ETFs with lower volatility such as banks and utilities which may have lower option yields but may pay higher dividend yields; to sectors with low (or no) dividends but higher volatility and therefore higher covered call yields such as software stocks.

Time and volatility are two of the key elements for determining an options value. So, when the underlying instrument (whether a stock, bond, or anything else) has higher volatility, its option’s will yield more income as covered calls. This means writing covered calls on more volatile instruments will generate more option premium (i.e. higher income for covered call strategies).

Where do crypto covered call ETFs fit in?

With the facts about covered calls in mind, cryptocurrency covered call ETFs have high yields because cryptocurrency prices are themselves highly volatile. For example, the implied volatility on the stock market (represented by the S&P 500) at the time of writing is around 30, whereas the implied volatility of Ethereum is close to 80.

Investors can expect to generate higher incomes by using covered call option writing strategies with cryptocurrencies compared to the general stock market. This is what makes crypto covered call ETFs so appealing.

Because of their high yields, covered call ETF strategies are increasingly popular in today’s low rate environment.

Bitcoin Yield ETF & Ether Yield ETF

The Bitcoin Yield ETF and Ether Yield ETF issued by Purpose Investments are covered call ETFs that harness the volatility of each cryptocurrency to deliver income for investors.

Let’s dive into the specifics of these two crypto covered call ETFs: the Bitcoin Yield ETF and the Ether Yield ETF.

Basic Strategy

The basic strategy of these two crypto covered call ETFs are essentially the same. One yield ETF is for bitcoin, the other is for Ethereum. Bitcoin is a little less volatile compared to Ethereum, so the yield on the Bitcoin Yield ETF is a little lower than the Ether Yield ETF.

Each ETF holds shares in their respective cryptocurrency ETF and then the portfolio manager writes covered calls against these positions. This is what generates the income for investors. Otherwise, simply holding a cryptocurrency ETF generates no income.

Coverage Ratio

The level of coverage and the income investors receive is determined by the strategy the portfolio manager takes. The covered call crypto ETFs being discussed do not write covered calls on 100% of their portfolios. Instead, the portfolio manager will limit the covered calls they write to less than 50% of the value of the portfolio.

For example, at the time of writing the Bitcoin Yield ETF had written options to cover 28% of its portfolio. This leaves investors with more upside (or downside) in the price of bitcoin compared to writing options on 100% of the portfolio.

Writing covered calls on only 28% of the portfolio also generates less income for investors compared to writing options on 100% of the portfolio. This trade-off is a tactical decision made by the portfolio manager of these ETFs.

Some covered call ETFs have strict criteria about how the ETF writes options and generates income from covered calls. While other covered call ETFs take a tactical approach and allow the portfolio manager some discretion. There are pros and cons to each way.

Having strict criteria for the portfolio manager running a covered call ETF allows investors to plan for the specific strategy of the ETF within their portfolio. Investors can be sure the ETF will perform as designed. However, a tactical or active approach to managing a covered call portfolio gives the portfolio manger some discretion about which covered calls to write allows for more flexibility.

The Purpose Investments covered call crypto ETFs give the portfolio manager some discretion about which options to write. This allows the portfolio manager to take a tactical approach and tilt the portfolio towards being more defensive by generating more income from writing more options on a greater coverage of the portfolio or by writing less options and writing more out of the money options to give the portfolio greater potential upside to a rise in the price of bitcoin and Ethereum.

Investors may prefer a more active or passive approach to a covered call writing strategy based on their investment objectives (and investment philosophy). The key point to remember for investors in these crypto covered call ETFs is the manager has some discretion.

A crypto covered call strategy is less risky

When we consider the range of choices investors have when deciding to gain exposure to cryptocurrency ETFs, they can choose from several positions. They could buy call options, which would give them the most bullish exposure. They could borrow to invest in crypto ETFs or hold crypto ETFs outright. They could hold covered call crypto ETFs. And, they could even buy put options to bet against the rising value of cryptocurrencies.

Holding covered call crypto ETFs is less risky compared to holding cryptocurrency ETFs outright. The income provided from the covered call decreases risk. So, investors who may be put off by holding cryptocurrency ETFs outright because of their high volatility may find covered call crypto ETFs more appealing. This doesn’t mean crypto covered call ETFs aren’t risky, they are. We just need to keep in mind that when considering a range of ways to invest in cryptocurrencies, buying covered call ETFs is less risky compared to holding cryptocurrency ETFs outright.

The crypto covered call ETFs offered by Purpose Investments provide HIGH yields. At the time of writing, the yield on the TSX 60 index is around 2.50%, whereas the distribution yield on the Purpose Ether Yield ETF is 17%. This huge income has tax consequences that investors should also consider.

Tax Consequences

The tax on income generated from a crypto covered call ETF can generally be treated as capital gains. This makes crypto covered call ETFs fairly tax efficient. If this tax treatment were to change (or if the capital gains rate changes) or if your tax advisor recommends treating the income from crypto covered call ETFs as regular interest income, then the best place to hold crypto covered call ETFs would be inside a registered account or another tax except account such as charitable foundation.

Who are these ETFs suitable for?

Investors with private foundations should seriously consider adding crypto covered call ETFs to their charitable endowment portfolio. Since the income earned by private foundations is tax exempt, it doesn’t really matter what the nature of the income received from covered call ETFs is. The high income generated by crypto covered call ETFs is tax free to a charitable foundation. With fixed income yields so low, many private foundations are searching for ways to generate more income to fund their commitments. Cryptocurrencies are highly volatile and speculative, so such investments are only suitable for private foundations that have clearly carved out a section of their asset allocation for such investments. Cryptocurrency ETFs should also only represent a small portion of an endowment portfolio.

Income Investors

Investors searching for income might consider crypto covered call ETFs, but only for a small portion of their overall portfolio. The yield on the Bitcoin Yield ETF and the Ether Yield ETF are quite large and the returns are uncorrelated to most other asset classes. But, the underlying cryptocurrency assets themselves are very volatile. So, this means unless an investor is super keen to get exposure to cryptocurrency, these crypto covered call ETFs should be avoided or held in very small amounts.

Who should avoid these ETFs?

Cryptocurrencies are highly volatile and not suitable for any investor concerned about preservation of their capital. Retirees with little knowledge of cryptocurrencies should probably not invest in crypto covered call ETFs even though the income they generate is large. Retirees looking for income might be better off considering covered call ETFs on blue chip stocks instead.

The Yields are Huge

At the time of writing the Bitcoin Yield ETF and the Ether Yield ETF only have $34 million and $55 million of AUM respectively. So, these ETFs are still quite small. The yield of the Bitcoin Yield ETF and Ether Yield ETF are 13.32% and 16.29% respectively. This means they are yielding far higher than what can be obtained from a portfolio of blue-chip stocks (even a levered portfolio).

Different Share Classes

Many Canadian listed ETFs nowadays have multiple share classes, and this is because they are trying to appeal to American investors wanting to deal in US dollars. Most cryptocurrency ETFs have a Canadian dollar version and a US dollar version. In the case of the cryptocurrency covered call ETFs offered by Purpose Investments, there are actually three classes of each fund. The Bitcoin Yield ETF has a Canadian dollar traded fx hedged unit (BTCY), a non-fx hedged unit (BTCY.b), and a US dollar traded unit (BTCY.u). The same structure applies to the Ether Yield ETF (ETHY).

Is this a Free Lunch?

Even though crypto covered call ETFs offer high yields compared to other covered call ETF strategies, investors should not treat them as a free lunch. Investors in crypto covered call ETFs are trading off the upside of bitcoin and Ethereum for the income their volatility generates. If the price of bitcoin goes up 10x in a year, covered call ETF investors won’t receive this same return. Covered call investors will see their gains are capped in fast rising markets, and the income they receive will be their trade-off.

Before deciding to add a crypto covered call ETFs to your portfolio, you should first define your investment objectives and determine your approach to asset allocation. Most investors should only invest a small portion of their overall portfolio in things such as cryptocurrencies and gold. These types of investments may provide some uncorrelated returns and maybe some protection against inflation, but they are not productive assets the way stocks, bonds, or most real estate are.

Typically, investors may choose to allocate up to 10% of their portfolio to cash and other alternatives such as cryptocurrency, gold, fine art, coins, and other collectibles. Most of the time, wealthy investors should be holding most of their assets in blue chip stocks, income producing real estate, and some fixed income investments.

Crypto Covered Call ETFs