Twins at the Crossroads: Covered-Call ETFs vs Total Return
Over 25 years ago, I first learned about options trading. I never got around to implementing any such strategies for my accounts, but unexpectedly, I found myself in the investment industry, initially serving U.S. investors at a discount brokerage that had a contact centre here in London, Ontario. Despite my hesitancy, I discovered that many DIY investors were quite enamoured with these highly speculative “derivative” products. With only a relatively small amount of money, you could potentially put yourself in a position to purchase a large block of stocks at a discount. This is a long call position. Or at the other end, you could receive a “premium” in exchange for potentially having to sell away your underlying stocks for a set price. This is a short call position that is “covered” by you owning the stock in advance of selling the call. The goal of a covered-call position is ideally to generate income, while the secondary purpose is to modestly mitigate the loss if the underlying stock declines in value.
Although covered-call trading is among the least risky approaches to take when it comes to investing, it is not without risk, and it also takes considerable vigilance over your investment portfolio to know when to get out of your current position and “roll” it into another. It’s definitely not a buy-and-hold or “set-it-and-forget-it” approach.
These days, covered-call strategies have been packaged into Exchange-Traded Funds or ETFs. As an example, let’s use one of the most popular covered-call ETFs, ZWB, the BMO Covered Call Canadian Banks ETF. The holdings of this ETF consist of: 1. ZEB, the BMO Equal Weights Banks Index ETF, which holds the six largest Canadian banks (Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, and National Bank of Canada) in approximately equal proportion; 2: the same six banks held individually; and 3: a series of “out-of-the-money” calls that are written (sold) against these underlying banks. Since the ETF holds these underlying stocks, the calls are considered “covered.” As the calls expire, new calls are written to earn more premium income. BMO writes that the “option premium provides limited downside protection.” As I described then, the purpose is to generate income and reduce the potential for loss.
Income has a lot of appeal. I was listening to a U.S. podcast, Animal Spirits, and the hosts observed that investing for income shows continuing popularity in their country as well. But is a focus on income the best approach for long-term investors? In today’s blog post, I discuss the relative benefit of a covered call strategy versus total return investing.
Introducing Christopher and Ashley
Christopher (Chris) and Ashley are fraternal twins. They have the same upbringing and the same access to education and financial literacy. Both are turning 42 in 2025.
Despite those similar backgrounds, as they settle into midlife and get more serious about financial planning, their investing philosophies evince startlingly different approaches.
Chris is drawn to income-generating investments and has taken a particular interest in covered-call ETFs because they promise predictable cash flow and less volatility than a regular index ETF.
Ashley leans toward a total-return strategy. Her investment portfolio consists of broad global equity exposure and low-cost index investing. Her focus is on portfolio growth over time.
Contrasting The Twins’ Approaches
The contrast between the twins seems simple at first.
Chris likes to see monthly distributions; the cash flow is a comfort to him and is a sign of portfolio productivity.
Ashley sees Chris’s yield chasing as a distraction from the long-term growth of her portfolio. Then she asks, are those monthly payouts income in the way Chris thinks?
Christopher’s Approach: The Allure of Covered-Call ETFs
Chris likes the yield generated by these ETFs. He observes that ZWB, the ETF that writes calls against Canada’s major banks, is by far the most popular ETF in Canada, but even he recognizes that basing his entire investment portfolio on an ETF that holds six Canadian banks is too concentrated. So, instead, he has chosen a globally diversified approach by including covered-call ETFs that cover a broader range of the Canadian market, as well as covered-call ETFs with similar purposes that track U.S. and European markets.
*Note: Yields as of mid-2025; actual may vary. Always verify via fund websites.
Because Chris plans to grow his investments until he retires in about 20 years or so, he will continue to reinvest the distributions in his RRSP and TFSA accounts. He’s not particularly concerned about the nature of the income since he doesn’t have a non-registered account. Furthermore, he has no plans to withdraw from either of his accounts until he retires and converts his RRSP into a RRIF. At that time, he hopes that the size of his portfolio and his income-generating strategy will permit him to generate enough income that he won’t need to sell any of his assets.
Sources of “Income” in Covered-Call ETFs
Let’s take a look at the distributions from ZWC, ZWH, and ZWP:
ZWC and ZWP are quite consistent. ZWC generates eligible dividend income, while ZWP’s dividends, since they come from Europe, are treated as foreign income. That also applies to ZWH, which holds a portfolio of U.S. dividend payers. Note that the foreign income figures are shown after the foreign taxes paid have been deducted.
You may be wondering about the Return of Capital. One big reason that these ETFs use covered-call strategies is to boost their payouts. These strategies earn option premiums, a kind of extra income the fund generates by giving up some of the future upside in the stocks it holds. For tax purposes, this option premium is classified as a Return of Capital or ROC.
This won’t have an impact when holding these ETFs in RRSPs or TFSAs, but if held in a non-registered account, it will need to be carefully attended to.
Let’s compare these three ETFs. ZWH stands out as the outlier. In 2024, only about 2% of its distribution was classified as return of capital (ROC), while a striking 68% came from capital gains. Like other BMO covered-call ETFs, ZWH aims to provide consistent monthly income. But when option premiums or dividend income fall short, the managers may need to sell some of the underlying holdings to meet the distribution target. These sales can generate capital gains, which are then taxable in the year they’re distributed. While this may reflect a productive portfolio, it introduces more variability in both portfolio composition and tax treatment from year to year.
It’s also possible that a significant number of ZWH’s call options expired “in the money”—that is, the stock price rose above the strike price before expiration. In that case, the fund would have been obligated to sell the underlying securities, often at a profit. These transactions would also result in realized capital gains that must be passed on to unitholders.
Ashley’s Approach: The Total-Return Mindset
Ashley invests in broad-based, low-cost ETFs. Conveniently, this is available in a single ETF, the two biggest being XEQT from BlackRock’s iShares and VEQT from Vanguard. A third such popular ETF is ZEQT from BMO.
Like Chris, Ashley has chosen an all-equity portfolio. This table includes only the 100% equity asset-allocation ETFs.
Ashley’s plan includes reinvesting the distributions. Like Chris, she only has RRSP and TFSA accounts and doesn’t need to worry about tracking the ACB for tax purposes.
Both Chris and Ashley have their investment focus on long-term growth, but for that very reason, Ashley sees no need to focus on income, whether from covered calls or dividends.
In retirement, Ashley feels comfortable with the idea of withdrawing from her accounts by selling portions of her assets as necessary and not relying solely on distributions.
Here’s What’s Going ON…
The siblings are a study in contrasts. Chris is focused on income, while Ashley sees Chris’s approach as a distraction from the main goal of long-term growth.
Key Observations:
- Opportunity Cost
Covered-call strategies cap the upside. If the underlying stock or sector performs well, much of that growth is surrendered for the sake of yield. This may be what was happening with ZWH.
- Tax Efficiency
Ashley’s capital gains (deferred and taxed at lower rates) may prove more efficient than Chris’s fully taxable option income, especially in a non-registered account. First, capital gains are not subject to foreign taxation. Second, even within RRSPs and TFSAs, there may be an advantage because there will be relatively less income that is subject to foreign withholding tax.
- Total Return Dominance Over Time
While income strategies can outperform for a period, Ashley’s total-return approach often outpaces an income-focused strategy, even after accounting for distributions.
A Transformative Moment
Chris, whose sister was older than him by a few minutes, felt he should listen to his older sister and at least explore whether his emphasis on yield from covered calls made sense. Still wedded to the idea that yield is important, he compared the 1-year returns of his global covered-call portfolio components to equivalent dividend-focused ETFs that did not use covered calls.
To his surprise, the European covered-call ETF did quite a bit better than the income-oriented ETFS he compared them against, but he discovered that the Canadian and U.S. covered-call ETFs were not quite as good when he considered dividend yield and price return together.
This result has Chris reconsidering his strategy. Although he likes income, he’s more aware that the income from a covered-call strategy is not inherently superior to a more “plain vanilla” portfolio that avoids covered calls.
For Ashley’s part, she remains confident that her focus on a low-cost, broadly diversified global equity portfolio has the potential to outperform most other strategies over the long term, and is content to stick with her approach, even if there will be times when it may not be the top performer.
What This Means Going Forward
For the income-seeker like Chris, one of the lessons to be learned from this analysis is that it is important to understand the sources of distribution income. People who invest in ETFs tend to casually refer to “dividends” when there are payouts from an ETF, but the income could come from a variety of payments.
While covered-call ETFs may have their appeal in their larger distributions, they should probably be used sparingly, if at all, and not as core holdings. It is often noted that when a stock pays out an unusually high dividend, it may be masking a deeper problem, like an impending dividend cut, and probably comes at the expense of growth.
The corollary of this observation is that income distributions need to be balanced by a concern for total return. If you are only getting income but are seeing little to nothing in the way of growth in the assets, is this a sustainable investment?
For those like Ashley, oriented toward total return, you may not see substantial “income,” but the important thing to observe is that your portfolio is growing. Instead of counting exclusively on distributions of cash from your portfolio, which is difficult to accomplish at the best of times, use a systematic withdrawal strategy to generate retirement income. Your focus is on after-fee, after-tax total return.
This is the 295th blog post for Russ Writes, first published on 2025-07-07.
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