Hub Blogs

Hub Blogs contains fresh contributions written by Financial Independence Hub staff or contributors that have not appeared elsewhere first, or have been modified or customized for the Hub by the original blogger. In contrast, Top Blogs shows links to the best external financial blogs around the world.

Call Option ETFs showed their value in 2022

This was not an easy year for markets, but one asset class delivered cash flow for investors despite these headwinds

Pixels/Javon Swaby

By Paul MacDonald, CFA, Harvest ETFs

(Sponsor Content)

After the euphoria of 2021’s everything rally, 2022 brought many investors right back down to earth. The asset classes that led in the latter periods of the most recent bull market  lost ground in this year as the ‘permacrisis’ — Collins dictionary’s word of the year — was felt across markets and asset classes since the end of February.

We know the story: inflation, supply chain challenges, rate hikes, and war in Ukraine all conspired to wreak havoc.

As the graphs below show, few areas of the market were immune from 2022’s tribulations.

 

Source:  Bloomberg, Harvest Portfolios Group Inc. December 21, 2022

Sector & Market Returns YTD

 

Source:  Bloomberg | Data as on December 22, 2022; prices normalized to 100 (starting December 31, 2021)

While markets have been decisively in the red for the year, the path has been marked by significant volatility spikes – both to the upside and downside.  As a proxy for volatility, the VIX Index, aptly called the CBOE Volatility Index, visually shows the volatility spikes that were experienced by most investors. One can also see that volatility has been at levels on average that are meaningfully higher than in recent history.

Source:  Bloomberg, December 20, 2022.  Additional Information:  https://www.cboe.com/tradable_products/vix/

The dramatic and volatile swings in equity markets outlined above should, in a normal year, have been offset by investors’ bond holdings. That’s the logic of the traditional 60/40 equity/bond portfolio.

2022 was not a normal year. Rising interest rates pushed down the value of bonds at the same time as equities were falling. The FTSE Canada Universe Bond Index, for example, was down 9.91% YTD as at December 21st.

Certain funds in one asset class, despite the negative overall returns in the market, were able to earn and deliver solid tax efficient cash flows for investors by monetizing some of the market volatility: call option ETFs.

What are call option ETFs?

Call Option ETFs — also called equity-income ETFs — are investment funds that hold portfolios of equities, but use call option strategies to generate income for unitholders. Those call option strategies trade a certain amount of market upside potential for certainty of some cash flows during a specific period: selling the option to buy a stock tomorrow at today’s price in exchange for a premium. Call Option ETFs pass those premiums on to unitholders as tax-efficient cash flow. They forego a certain amount of market upside, if markets swing higher, but generate a consistent amount of ‘income’. A ‘bird in the hand’ as it were.

That ‘bird in the hand’ income came at high rates in 2022. Many of Harvest’s call option ETFs had annualized yields  of more than 8% or even 10% during the year. That income — when considered a portion of total returns — was able to offset some of the losses in underlying equity values through the year, as the below example of the Harvest Healthcare Leaders Income ETF (HHL:TSX) demonstrates.

For illustrative purposes only.

The chart above is based on a hypothetical initial $100,000 CAD investment and only shows the market value per unit of Harvest Healthcare Leaders Income ETF (“HHL”) using the daily market close on the TSX and identifies the monthly cash distributions paid by HHL on a cumulative basis. The cash distributions are not compounded or treated as reinvested, and the chart does not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder. The chart is not a performance chart and is not indicative of future market values of HHL or returns on investment in HHL, which will vary.

Why actively managed call option ETFs offer advantages

All of Harvest’s call option ETFs use an active and flexible call option writing strategy. That means the ETFs’ portfolio managers can sell as many or as few calls as they need to generate the ETF’s monthly distribution: up to a hard 33% write limit. That means at all times a minimum of 67% of each ETF’s holdings is fully exposed to potential market upside. It also allows these ETFs to capture market opportunities in a way that passively managed call option ETFs cannot.

Key to this advantage is the fact that options generate a higher premium when markets are more volatile. When stock prices swing wildly in the way they did throughout 2022, options cost more. Therefore the premium earned is higher. Since covered call ETFs sell options, they can generate the cash for their monthly distributions by potentially selling fewer options when markets are more volatile. This means that more of the ETF’s portfolio may be exposed to potential market upside compared to a passive systematic covered call strategy.

As much as 2022 was treated as a down year on markets, it’s notable that many of the volatile swings we’ve seen have been to the upside. By earning higher premiums from options during periods of volatility, Harvest ETFs have been able to capture some of those upswings, but have also been able to generate high and consistent cash flows for investors.

Many of the macro conditions that had negatively impacted markets in 2022 have shown signs of abating, too. Inflationary pressures have let off slightly, and the final Federal reserve rate hike of 2022 was only 0.5%: lower than the year’s cadence of 0.75% increases. If a less hawkish fed and signs of inflation dropping manifest more fully in 2023 we may see a market recovery. In such an instance these actively managed call option ETFs may be better able to capture more market upside than a passively managed call option ETF, but until that recovery is in full bloom, the Harvest ETFs can generate significant monthly cash flows.

The right strategy for the right time

In a year where everything seemed to be falling, many call option ETFs offered Canadian investors attractive income yields: paid monthly these were a source of returns at a time when returns were hard to find. The greater opportunities for upside capture afforded by an active & flexible call option writing strategy may give Harvest’s call option ETFs an advantage over passively managed ETFs.

As predictions for 2023 roll in, with the prospects of both market recoveries and economic recession on the horizon, the aspects of call option ETFs that delivered for investors this past year may prove themselves valuable once again. 2022 may have been the year call option ETFs announced their importance for Canadian investors, but we believe that importance will continue to be borne out in the years to come.

Paul MacDonald is the Chief Investment Officer and Portfolio Manager with Harvest Portfolios Group Inc. 

 

 

 

Commissions, management fees and expenses all may be associated with investing in HARVEST Exchange Traded Funds (managed by Harvest Portfolios Group Inc.) Please read the relevant prospectus before investing. The funds are not guaranteed, their values change frequently and past performance may not be repeated. All comments, opinions and views are of a general nature and should not be considered as advice and/or a recommendation to purchase or sell the mentioned securities or used to engage in personal investment strategies. Tax, investment and all other decisions should be made with guidance from a qualified professional.

Retired Money: Inflation and some compensations in federal tax brackets and contribution limits

 

My latest MoneySense Retired Money column has just been published and can be accessed by clicking the highlighted headline: Inflation and investments: Heads up if you’re retired or retiring soon

It looks at the anxiety of would-be retirement savers in the light of soaring inflation and in particular, a recent Leger Questrade poll that looked at how inflation is affecting Canadians’ intentions to contribute to TFSAs and RRSPs. My Hub blog on this includes 4 charts on the topic.

Not surprisingly, inflation is a particular concern for retirees and those hoping to retire soon. The 2023 RRSP Omni report found that while 87% of Canadians are worried about rising prices, it also found 73% of RRSP owners still plan to contribute again this year, and so do 79% of TFSA holders. That’s despite the fact 69% fret that inflation will impact their RRSPs’ value and 64% worry about their TFSAs’ value. Seven in ten with RRSPs and 64% with TFSAs are concerned about inflation and a possible recession: 25% “very” concerned.

A Silver Lining

The MoneySense column also summarizes some of the compensating factors that Ottawa builds into the retirement saving system: as inflation rises, so too do Tax brackets, the Basic Personal Amount (BPA: the tax-free zone for the first $15,000 or so of annual earnings), and of course TFSA contribution limits (now $6500 in 2023 because of inflation adjustments). This was nicely summarized late in 2022 by Jamie Golombek in the FP, and reprised in this Hub blog early in the new year.

Because tax brackets and contribution levels are linked to inflation, savers benefit from a little more tax-sheltered (or tax deferred) contribution room this year. The RRSP dollar limit for 2023 is $30,790, up from $29,210 in 2022, for those who earn enough to qualify for the maximum. And TFSA room is now $6,500 this year, up from $6,000, because of an inflation adjustment. As Golombek noted, the cumulative TFSA limit is now $88,000 for someone who has never contributed to one.

Golombek, managing director, Tax & Estate planning for CIBC Private Wealth, wrote that in November 2022, the Canada Revenue Agency said the inflation rate for indexing 2023 tax brackets and amounts would be 6.3%: “The new federal brackets are: zero to $53,359 (15%); more than $53,359 to $106,717 (20.5%); more than $106,717 to $165,430 (26%); more than $165,430 to $235,675 (29%); and anything above that is taxed at 33%.”

Another break is that the yearly “tax-free zone” for all who earn income is rising. The Basic Personal Amount (BPA) —the annual amount of income that can be earned free of any federal tax — rises to $15,000 in 2023, as legislated in 2019.

CPP and OAS inflation boosts in late January

 On top of that, retirees collecting CPP and/or OAS can expect significant increases when the first payments go out on or around Jan. 27, 2023. (I include our own family in this). There’s more information here. Continue Reading…

Benefits of a Core-Satellite Investment approach

By Erin Allen, CIM, VP Online ETF Distribution, BMO ETFs

(Sponsor Content)

Asset allocation is one of the most critical investment decisions an investor can make. Studies, such as the influential Brinson, Hood and Beebower paper, “Determinants of Portfolio Performance,1” suggest that the long-term strategic asset allocation of a portfolio accounts for over 90% of the variation of its return.

According to the study, the portfolio’s strategic – or target – asset allocation will have a greater impact on its performance than security selection or any short-term active or tactical asset allocation shifts.

The first step when constructing a portfolio is to determine the appropriate asset allocation, based on your risk profile and investment objectives, and then select investments across each asset class.

There are several approaches to constructing an investment portfolio. One such strategy is to adopt a core-satellite approach. Core-satellite investing involves using a core portfolio to anchor the portfolio’s strategic asset allocation, and adding satellite investments to enhance returns and/or mitigate risk.

Fundamentals of a core-satellite portfolio

A typical investment portfolio is comprised of traditional asset classes that represent the broad market, and generally include investment-grade fixed income securities and large-cap Canadian, U.S. and international equities, for example BMO S&P TSX Capped Composite Index ETF (ZCN), BMO S&P 500 Index ETF (ZSP), and BMO MSCI EAFE Index ETF (ZEA). These asset classes make up the portfolio’s “core” investments. Specific securities within each asset class will depend on the investor’s return objectives and risk tolerance.

In order to further diversify the portfolio, non-traditional asset classes – referred to as “satellite” strategies – are used to enhance returns and manage risk. Satellite strategies often have greater return potential than core asset classes, but may be considered higher risk (with greater volatility) when held on their own. However, they often have a lower correlation – a measure of the degree to which two investments move in relation to each other – to traditional assets classes. Satellite strategies can include asset classes or themes that can be used as either short-term, tactical investments, or held for longer periods of time. Combining investments with a low correlation can improve the risk/return characteristics of a portfolio.

Examples of satellite strategies are shown in Table 1 [below]. By using one or more of these satellite strategies in tandem with a core portfolio, investors can further diversify their portfolio across additional asset classes, regions, sectors, market capitalizations, currencies and/or investment styles. For example, real assets such as commodities, infrastructure and real estate have a tangible value that can rise during periods of inflation.

Infrastructure and real estate can also offer a steady and predictable cash flow.  Global fixed income securities provide Canadian investors with exposure to bonds in countries with different currencies and interest rate cycles, which can help reduce interest rate risk; while hedge funds, such as market neutral or multi-strategy funds, can actually lower volatility and improve a portfolio’s risk-adjusted performance.

Table 1: Courtesy BMO ETFs

Constructing a core-satellite portfolio

A core-satellite portfolio can be implemented by using:

  • Active strategies that seek to add value through security selection;
  • Passive strategies that seek to track the performance of an index representing a particular investment market;
  • A combination of active and passive strategies.

There is a fundamental investment theory that states markets are efficient and the price of any individual security already reflects all available relevant information, which makes it more difficult for active managers to outperform. Investors who share this view would generally purchase passive investments. Conversely, others believe markets are not efficient and do not always behave rationally, providing active managers with the opportunity to select undervalued securities and avoid overvalued securities – and increasing their potential to add value above the market and/or provide better risk controls and downside protection. While some studies show that the “average” active manager does not add value, well-selected managers have demonstrated the ability to add value and/or reduce risk over the long term.

One approach to constructing a core-satellite portfolio is to use passive investments for efficient markets and active investments for less efficient markets. Many traditional asset classes, such as the U.S. equity market, are considered to be very efficient, making it difficult for active managers to outperform. Non-traditional asset classes, such as Emerging Markets equities or high yield bonds, are often considered less efficient. Many of these asset classes may be more difficult to access, can be less liquid, and are not covered as broadly by research analysts, which can enable active managers greater potential to add value.

The most critical step

Determining the appropriate asset allocation (mix of stocks, bonds and other asset classes) is the most important step when building your portfolio. Whether you use a passive strategy, an active strategy, or a combination of both, the addition of one, or more, satellite strategies to a core portfolio can potentially enhance returns, reduce risk and provide a better return/risk profile for your portfolio.

Simple to use All-in-One Core Portfolio ETFs

BMO ETFs offers a range of all-in-one Asset Allocation ETFs you can select as your core investment portfolio, based on your risk tolerance and time horizon. These ETFs are a one-ticket solution where the asset allocation is determined by professional managers, and where the asset allocation is automatically rebalanced for you on a regular basis to ensure you are on track to meeting your goals. They are low cost, and there is no double dipping on the fees (all-in MER of 0.20%* includes the cost of the underlying ETFs).  Examples include our BMO Balanced ETF (ZBAL), or BMO Growth ETF (ZGRO) and BMO All-Equity ETF (ZEQT).  Click Here to learn more.

Erin Allen has been a part of the BMO ETFs team driving growth since the beginning, joining BMO Global Asset Management in 2010 and working her way through a variety of roles gaining experience in both sales and product development. For the past 5+ years, Ms. Allen has been working closely with capital markets desks, index providers, and portfolio managers to bring new ETFs to market. More recently, she is committed to helping empower investors to feel confident in their investment choices through ETF education. Ms. Allen hosts the weekly ETF Market Insights broadcast, delivering ETF education to DIY investors in a clear and concise manner. She has an honors degree from Laurier University and a CIM designation.

* Management Expense Ratios (MERs) are the audited MERs as of the fund’s fiscal year end or an estimate if the fund is less than one year old since the audited MER of the ETF has not gone through a financial reporting period.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

Commissions, management fees and expenses (if applicable) may be associated with investments in mutual funds and exchange traded funds (ETFs). Trailing commissions may be associated with investments in mutual funds. Please read the fund facts, ETF Facts or prospectus of the relevant mutual fund or ETF before investing. Mutual funds and ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

For a summary of the risks of an investment in BMO Mutual Funds or BMO ETFs, please see the specific risks set out in the prospectus of the relevant mutual fund or ETF .  BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

S&P®, S&P/TSX Capped Composite®, S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”) and “TSX” is a trademark of TSX Inc. These trademarks have been licensed for use by S&P Dow Jones Indices LLC and sublicensed to BMO Asset Management Inc. in connection with the above mentioned BMO ETFs. These BMO ETFs are not sponsored, endorsed, sold or promoted by S&P Dow Jones LLC, S&P, TSX, or their respective affiliates and S&P Dow Jones Indices LLC, S&P, TSX and their affiliates make no representation regarding the advisability of trading or investing in such BMO ETF(s).The BMO ETFs or securities referred to herein are not sponsored, endorsed or promoted by MSCI Inc. (“MSCI”), and MSCI bears no liability with respect to any such BMO ETFs or securities or any index on which such BMO ETFs or securities are based. The prospectus of the BMO ETFs contains a more detailed description of the limited relationship MSCI has with BMO Asset Management Inc. and any related BMO ETFs.

BMO Mutual Funds are offered by BMO Investments Inc., a financial services firm and separate entity from Bank of Montreal. BMO ETFs are managed and administered by BMO Asset Management Inc., an investment fund manager and  portfolio manager and separate legal entity from Bank of Montreal.

BMO Global Asset Management is a brand name under which BMO Asset Management Inc. and BMO Investments Inc. operate.

®/™Registered trademarks/trademark of Bank of Montreal, used under licence.


Despite inflation, Canadians still prioritizing retirement and contributing to RRSPs and TFSAs

While the vast majority (87%) of Canadians are worried about rising costs from Inflation, Questrade Leger’s 2023 RRSP Omni report finds that 73% of RRSP owners plan to contribute again this year, and 79% of TFSA holders plan to recontribute. That’s despite the fact 69% fret that inflation will impact their RRSP’s value and 64% worry about the impact on their TFSA’s value.

“The number of Canadians who are saving for retirement remains consistent with previous years,” the report says. “Among those who are saving for retirement, about three-in-five (58%) say they are very worried compared to Canadians who are not saving for retirement. Women are also more likely to be very worried about the costs associated with rising inflation.”

Seven in ten respondents who have RRSPs told the panel they are concerned about the rising costs associated with inflation and a possible recession: 25% indicate that they are very concerned. “A similar trend is observed among those who hold TFSAs for retirement purposes, with almost two-thirds (64%) indicating that they are concerned.”

 

Worries about inflation and recession “raise questions about the ability of Canadians to control their financial future, especially when it comes to retirement,” the report says. These concerns are most acute for those with an annual income of less than $100,000: “These Canadians are also more likely to agree that they will have to draw upon their savings or investments to cover their expenses in the coming year.”

Less than half are confident about their financial future

Less than half feel they are confident when it comes to their financial future: “Only those making over $60K have confidence in their own financial future despite the current state of the economy.”

The survey seems to imply that Canadians value TFSAs a bit more than RRSPs, based on willingness to max out contribution room of each vehicle. Of course, annual TFSA room only this year moved up to $6500 per person per year, less than a quarter of the maximum RRSP room of $30,780 in 2023, for those with maximum earned income.

Only 29% of RRSP holders plan to maximize their RRSP contribution room in 2023, compared to almost half (46%) who plan to max out their TFSAs. The most enthusiastic TFSA contributors are males and those aged 55 or older.

Given economy, most worry about rising cost of food and everyday items  

Day-to-day living expenses continue to be a concern in the face of rising inflation: 79% worry about rising food prices and 77% rising everyday items. The third major concern (for 45%) is inflation’s impact on savings/investments and fourth (at 30%) is rising mortgage costs. Depending on annual incomes, worry over inflation can centre either on investments or on debt:  those in the middle to upper income brackets ($60K or more) “are much more likely to find the impact on savings / investments and increasing mortgage concerns more worrisome than compared to those who make less than $60K.”

Ability to save impacted by inflation

Three in four (74%) agree that inflation has impacted their ability to save, at least somewhat. And half (47%) have had to draw upon their savings or investments to cover expenses due to rising costs, especially those under 55 and those who are not currently saving for retirement. Many Canadians also agree they will have to draw upon their savings/investments to cover expenses in the coming year (43%). Continue Reading…

TFSA contribution is Job One in 2023 and other inflation-related tax changes to consider

 

A belated Happy New Year to readers. Today I wanted to start with a reminder that your first Financial New Year’s Resolution should always be to top up your TFSA contribution to your TFSA (Tax-free savings account), which because of inflation has been bumped to $6,500 for 2023. I’ll also link to two useful columns by a financial blogger and prominent media tax expert.

A must read is Jamie Golombek’s article in Saturday’s Financial Post (Dec. 31/2022), titled 11 tax changes and new rules that will affect your finances in 2023. Golombek is of course the managing director, Tax & Estate planning for CIBC Private Wealth.

He doesn’t lead with the TFSA but does note that the cumulative TFSA limit is now $88,000 for someone who has never contributed to a TFSA. On Twitter there is a community of Canadian financial bloggers who often reveal their personal TFSA portfolios, which tend to be mostly high-yielding Canadian dividend-paying stocks. In some cases, their TFSA portfolios are spinning out as much as $1,000 a month in tax-free income.

On a personal note, my own TFSA was doing nicely until 2022, when it got dragged down a bit by US tech stocks and a token amount of cryptocurrency. Seeing as I turn 70 this year, I’ll be a lot more cautious going forward. I’ll let the existing stock positions run and hopefully recover but my new contribution yesterday was entirely in a 5-year GIC, even though I could find none paying more than 4.31% at RBC Direct, where our TFSAs are housed. (I’d been under the illusion they would by now be paying 5%. I believe it’s still possible to get 5% at independents like Oaken and EQ Bank.)

At my stage of life, TFSA space is too valuable to squander on speculative stocks, IPOs, SPACs or crypto currencies. Yes, if you knew for sure such flyers would yield a quick double or triple, it would be a nice play to “sell half on the double,” but it’s better to place such speculations in non-registered accounts, where you can at least offset capital gains with tax-loss selling. So for me and I’d suggest others in the Retirement Risk Zone, it’s interest income and Canadian dividend income in a TFSA and nothing else.

Inflation and Tax Brackets

Back to Golombek and inflation. Golombek notes that in November 2022, the Canada Revenue Agency said the the inflation rate for indexing 2023 tax brackets and amounts would be 6.3%:

“The new federal brackets are: zero to $53,359 (15 per cent); more than $53,359 to $106,717 (20.5 per cent); more than $106,717 to $165,430 (26 per cent); more than $165,430 to $235,675 (29 per cent); and anything above that is taxed at 33 per cent.”

Basic Personal Amount

The Basic Personal Amount (BPA) — which is the ‘tax-free’ zone that can be earned free of any federal tax — rises to $15,000 in 2023, as legislated in late 2019. Note Golombek’s caveat that higher-income earners may not get the full, increased BPA but will still get the “old” BPA, indexed to inflation, of $13,521 for 2023.

RRSP limit: The RRSP dollar limit for 2023 is $30,790, up from $29,210 in 2022.

OAS: Golombek notes that the Old Age Security threshold for 2023 is $86,912, beyond which it begins to get clawed back.

First Home Savings Accounts (FHSA). Golombek says legislation to create the new tax-free FHSA was recently passed, and it could be launched as soon as April 1, 2023. This new registered plan lets first-time homebuyers save $40,000 towards th purchase of a first home in Canada: contributions are tax deductible, like an RRSP. And it can be used in conjunction with the older Home Buyers’ Plan.

3 investing headlines to ignore this year

Meanwhile in the blogosphere, I enjoyed Robb Engen’s piece at Boomer & Echo, which ran on January 1st: 3 Investing Headlines To Ignore This Year. Continue Reading…