Enhancing your equity income with ETFs

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In today’s low interest rate bond environment, investors need to look elsewhere to add cash flow—and while equities are traditionally thought of as the growth engine of a portfolio, they can also be used to source cash flow. Ever since exchange traded funds, or ETFs, came on the scene a couple of decades ago, they’ve been touted as a low-fee way to invest and diversify your portfolio. ETFs have exposure in nearly all areas of investment, from equity income strategies, to sectors like healthcare and tech, to even global and emerging markets, which makes them very appealing to both new and experienced investors. If you’re like most investors, you probably have some ETFs in your investment portfolio (Canadian ETFs account for $289.2 billion, or more than 13% of investment funds). But you may not have considered them as a source of income. We’ll walk through some innovative ways to get cash flow from your equity portfolio, through ETFs that use enhanced income strategies, as well as through better-known dividend and REIT ETFs.

Enhanced income ETFs

This involves one of the more complex investing strategies, so let’s begin by breaking it down. It starts with the underlying portfolio, where the fund manager can invest in a broad dividend portfolio, or a focussed sector or industry strategy. It can help to have a strong dividend base to support the cash flow from the ETF, such as bank stocks, but the fund can also invest in a more growth-focussed sector, like technology stocks. Keep in mind that this portfolio will make a significant contribution to the ETF’s returns. Then, the fund manager applies a covered call strategy to increase the cash flow from the portfolio. This enhancement means selling potential excess upside on the portfolio in exchange for cash upfront in the form of call option premiums. For income-focussed investors, this can be a very appealing tradeoff. When you sell a call option, the contract has a price at which the purchaser can exercise the option to buy the underlying stock. They have paid a premium for this option of an agreed-upon dollar price per contract. If the price of the stock rises above the exercise price, the purchaser can exercise their option. If it falls below the agreed-upon price, the purchaser can just let the option expire. So, how does this generate income? Daniel Kent, founding partner at Stocktrades.ca, explains: “The end goal if you’re selling [a call option] is for stock prices to remain flat so that you can not only keep your shares you sold the call option on, but also keep the premium you got paid to sell the option,” Kent explains. “That is how these covered call ETFs provide more income for their investors.” Overall, he thinks covered call ETFs are a good strategy for the investor who prefers more income (in the form of dividends and capital gains) over total returns. That could be someone who is retired and prefers income over growth, and wants to be able to fund expenses. ETFs that offer a covered call option strategy include BMO’s Covered Call Canadian Banks ETF (ZWB), Global High Dividend Covered Call ETF (ZWG) and US High Dividend Covered Call ETF (ZWH). These products use the covered call strategy described above, but limit it to 50% of the portfolio in each case, so investors get exposure to market growth, as well. And because they hold dividend-paying investments, these ETFs generate income in two ways: from dividends and option premiums. It is important to see if these strategies still capture some market growth, which helps fund future cash flows, as the call writing strategy can limit the upside in the ETF. Look for ETFs that write out of the money, short dated options to allow stocks to appreciate, and ETFs that only write on a portion of the portfolio. If covered call ETFs aren’t for you, there are other ways to earn income from equity ETFs.

Dividend ETFs

Dividend ETFs hold a basket of investments that provide regular shareholder payouts. Many pay dividends either monthly or quarterly, which means you can earn income simply by buying and holding them in your portfolio. Dividend ETFs also contain a growth component, as the underlying portfolio can grow over time, in addition to being a source of dividend income. That results in more wealth via capital gains. In addition, the income is taxed as capital gains and dividends, which is more tax-efficient than traditional income products. Some companies pay out dividends in cash while others may reinvest back into the business, so when you’re looking at the companies held in an ETF, take a look at what they do with their dividend payouts. The good thing is that companies that usually offer dividends are big and established and pay out dividends based on earnings or reserves. That means dividends are not affected by market fluctuations and will come regularly—meaning, your dividend income is fairly stable. However, if the company experiences a downturn, such as happened with airlines during the pandemic, it may choose to suspend or reduce dividend payouts. ETFs that offer dividend exposure include BMO’s Canadian Dividend ETF (ZDV), BMO’s US Dividend ETF (ZDY/ZDY.U/ZUD), and BMO’s International Dividend ETF (ZDI/ZDH).

Real estate investment trust (REIT) ETFs

If you want to invest in real estate for the income but don’t want to be a landlord, a REIT ETF is an option to consider. REITs make money from the sales, rent and service income from the real estate industry (hotels, condos, office buildings, warehouses, etc.). They typically deliver investors higher cash flow than traditional equities, so they can be an excellent addition to portfolios. BMO’s Equal Weight REITs Index ETF (ZRE) offers exposure to the Canadian REIT sector.

How to add equity income ETFs to your portfolio

If you follow certain stocks, ETFs publish their holdings daily, so you can easily see the ETFs’ exposure to companies and industries. ETFs also add transparency by following indexes or typically published rules-based strategies, so you don’t get surprises in the portfolios. You can work with your advisor to determine which ETFs are right for you; if you’re a DIY investor, you can buy them through an online brokerage firm, or you can invest using a robo-advisor. Whatever approach you choose, ETFs are a great way to add income to an equity portfolio.