Return Of Capital in Covered Call ETFs
I'm diving deeper down the rabbit hole and trying to learn as much as I can.
ROC was a hot topic in my last posts so let's dig into it.
Turns out there are two types of ROC…..Good and Bad.
The bad kind is when YOUR CAPITAL IS GETTING RETURNED TO YOU.
This is done when the ETF is unable to meet its target distributions.
These ETFs will sell assets in the fund and return them to you as a shareholder in an effort or obligation to maintain that target distribution.
Lets look at HHIS as an example:
1 year performance is 17.6%
Current Yield is 26.58%
How do you pay someone a 26.58% return when your fund only made 17.6%? You return the capital to the investor by selling shares and including the money in their monthly payment.
But what happens when you sell shares? The price declines….
That is why HHIS is down 12% over the last year while the S&P is up 16.5%.....
HHIS does not make enough money to meet target distributions so they are returning money to shareholders through distributions by selling assets.
I have seen a couple of people argue about the tax benefits of this but here is what actually happens.
When you receive $1 of ROC on an ETF with a $10 cost basis, that $1 is not taxed as income and instead that $1 reduces your average cost base. What does this mean?
You don’t pay tax when you receive the income, you pay tax on it when you sell the shares and your new cost base is $9 instead of $10
And it will only help you in a taxable account, this does nothing for you in a TFSA or RRSP account. Â
So basically, you are paying HIGH management fees to have an ETF move your money around…
Now what is GOOD ROC?
This is when an ETF hands you a distribution that is legally classified as ROC but it does not erode the funds underlying asset value or NAV. (they didn’t have to sell assets to fund the distribution)
Basically these are accounting strategies that allow fund managers to classify real returns as ROC for the tax advantage I mentioned above.
They are basically repackaging profits as ROC to save investors on taxes and defer the payments.
So how do you tell when it is good or bad?
Very simple…..
Total returns need to be higher than the distribution.
If an ETF pays you 27% but only earns 16%, then YOU are making up the difference and paying an ETF high fees to move your money around and then RETURN IT BACK TO YOU.
If you buy Covered Calls, check the TOTAL RETURN vs TARGET DISTRIBUTION before you buy. The longer the time horizon the better.
MSTE, ETHY-B, HBTE, HHIS, and BIGY all payout more in distributions than they have returned over the past 2 years...... so if you like high fees, taxes, and lower returns, then these are for you!
High distributions are great for marketing but if the fund can't make enough to cover the distributions then I just can't see any scenario where this makes sense for an average investor.
Let it rip in the comments and we can keep this routine going!
