What are enhanced yield ETFs?

Enhanced yield ETFs have rapidly gained traction with investors, with assets in these strategies reaching $21.2 billion by the end of the first quarter of 2024.¹ These ETFs use options to generate income and shape the return profile of the underlying investment. The growing appeal of these ETFs can be attributed to several factors.

Both equity and fixed-income markets have seen an elevated level of uncertainty in recent years, experiencing choppy returns amid concerns about soaring inflation, recession fears, and geopolitical tensions. In response to these market conditions, investors have turned to enhanced yield ETFs to mitigate risk. These ETFs can potentially offer additional protection from market drawdowns while still allowing investors to maintain exposure to a specific area of the market, making them an attractive option in neutral or choppy markets.

Enhanced yield ETFs also receive income from selling call options, with yields often in the high single digits. This income stream makes them an appealing choice for investors who are seeking yield.

To gain a deeper understanding of these ETFs and how they’re structured, let’s review the basics of options: how they work and how they might be used within an enhanced yield ETF.

What are options?

An option is a financial contract between two investors. The investor who buys an option acquires the right, but not the obligation, to buy or sell a specific asset at a predetermined price (strike price) within a specified time frame. The price paid for this right is called the option premium and is paid to the seller of the option.

Call options give the buyer the right to buy a security at a specified price, while put options give the buyer the option to sell a security at a specified price. These options can be used or combined in various ways for hedging, speculation, or income generation. The value of options fluctuates before their expiration, and they can also be bought and sold right up until they expire.

Options traders use specific terminology to describe the relationship between an option’s strike price and the current market value of the underlying asset. If an option is “out of the money,” it means that for a call option, the underlying security is trading below the strike price and for a put option, the underlying security is trading above the strike price. Assuming the price remains constant, this option is unlikely to be exercised at expiry, as the option buyer can obtain a more favorable price in the market.

Conversely, an option is considered “in the money” when the underlying security is trading above the strike price for a call option and below the strike price for a put option. In this case, the option provides the buyer with the right to purchase the security at a lower price or sell the security at a higher price than is currently available in the market. As a result, it’s likely to be exercised at expiration if the price remains constant.

An option that is “at the money” is trading at its strike price. While this option could technically be exercised at expiry if the price remains constant, options are generally only exercised when they’re in the money, allowing the holder to make a profit net of commissions and fees.

How does a covered call work?

Covered call strategies own the underlying security and simultaneously sell a call option on that security, allowing the ETF to collect the premium from writing the option. This generates income and offers a bit of a buffer should the underlying security sell off. These ETFs often sell out of the money calls, meaning the option's strike price is higher than the current security price at the time of sale. While this lowers the premium collected, it offers the ETF holders some of the upside should the stock rise between the time the option is sold and the expiration. However, this upside is limited as the option is likely to be exercised if the security price exceeds the strike price at or prior to expiration.

In summary, the fund’s return comes from the income received from selling the option, as well as any upside return from the underlying security, while remaining below the strike price. In the example below, the ETF receives $15 from writing the call option with a strike price of $115. The fund will net a positive return as long as the underlying security doesn’t fall by more than $15 and can benefit from an upside move in the security until it reaches the strike price of $115.

How does a collateralized put work?

Collateralized (or cash-covered) put strategies typically sell a put option on an underlying security while keeping the equivalent, or “notional,” cash amount to match any potential purchase obligations.

These ETFs will typically sell at-the-money puts. This means that the strike price of the option will be at or slightly below, the price of the underlying security when the option is sold. At-the-money puts provide higher premiums than out-of-the-money puts.

In the example below, the ETF receives $15 from selling the put option with a strike price of $100. The fund also receives $2 in cash interest on the cash collateral during the life of the option. The fund will net a positive return if the underlying security doesn’t fall below $83.

The complexity of understanding and trading options can be overwhelming for many investors. Enhanced yield ETFs―which use covered calls and collateralized puts―offer a packaged and liquid strategy that provides access to a unique return profile with one simple and cost-effective trade.

These ETFs also provide the added benefit of professional management, simplifying the process for investors. It’s important to note that these strategies may not be suitable for everyone, but for those who are comfortable with the associated risks, investing in covered call and collateralized put ETFs can effectively harness the potential of these strategies while minimizing the complexities typically associated with options trading.

1 Manulife Investment Management, Bloomberg, as of March 31, 2024.