How to Create Your Own Massive Yield Fund

Time and time again I get asked some variation of the following question:

Why don’t you just throw up your hands and put all your capital into one of these ETFs that offer a 10%+ yield?

It’s a valid question. My portfolio yield is a hair over 3% these days, and we spend a good chunk of that income — while reinvesting some to help keep the income stream above inflation. If I were to move all my capital into one of those income ETFs that offers a much higher yield I could triple or even quadruple my spending. I’d go from searching for grocery deals to making it rain like a rapper in the club.

I don’t invest in these products for the following reasons:

If you’re an investor who values the income these products generate over and above all other things, then by all means. Knock yourself out. But I have a funny feeling that not a lot of these folks truly understand what they’re getting into here. They see the yield, ignore all else, and fall in love. “Oh wow. I can spend so much money!”

In short, they don’t understand how the sausage is made.

I think it’s important to have that understanding, and there’s no better way to do that than deconstructing one of these funds and creating your own version. Plus, it can give the rest of us some ideas or tactics we can use to squeeze a little extra yield from our portfolios.

A key component in a big chunk of these funds is leverage. They will typically borrow up to 25% of the fund’s value. For every $100k invested, the fund borrows an additional $25k. Then, as the value of the investments go up, the leverage is increased with it. A regular investor would probably want to pay the debt back at some point, but these funds do not.

I wrote more about borrowing to invest, if y’all are interested.

The income is then collected on the $125k investment, but the yield is expressed in terms of the $100k.

Let’s do a very simple example. You put in $100k and borrow an additional $25k. You’re up to $125k, and you put every nickel into South Bow (TSX:SOBO), the relatively recent TC Energy (TSX:TRP) oil pipeline spinoff. That will get you 2,520 shares based on the current price, which is $49.60 per share as I type this. This stock is offering a yield of 5.56%.

South Bow pays a US$0.50 per share quarterly dividend, which works out to $0.69 per share (nice) in local currency. That’s $2.76 per share each year. Multiply that by 2,520 shares, and you’re getting income of $6,955 on an annual basis.

Borrowing to invest always has a cost. The lowest cost margin in Canada comes from Interactive Brokers, which would charge 3.55% interest on the balance. That works out to $888 on an annual basis.

Take the second number away from the first, and you’re left with income of $6,027.

The leverage minus the cost of interest works out to a hair over a 6% yield on the $100k original investment. Basically, you get:

As we can see, the leverage isn’t really creating a big impact. Sure, it’s helping, but we need a little more to get to a double-digit yield. We need to get a little frisky up here in this hiz-house.

(That sound you heard was every person under 30 in the country laughing at my embarrassing attempt to be cool)

So let’s talk about covered calls next, which are really doing the heavy lifting here.

I’m going to make this next part as simple as possible, mostly because these funds typically operate fairly simple covered call strategies. There’s no real secret sauce here; it’s a formula you or I can easily replicate at home.

First, what’s a covered call? This is when you sell a call option on a stock you already own. When you sell the option, you immediately get a bit of income (the premium) for doing so. But in exchange for that income, you’ve created an obligation to sell at a certain price on a certain day.

Since you already own the stock, this obligation isn’t a big deal. The broker just sells your stock.

Let’s look at a real life example, sticking with South Bow. Based on the last trading price on Friday, a South Bow $52 June 19th covered call would net me proceeds of $0.26 per share. Multiply that by our 2,520 shares, and I would get income of $655.

That works out to a 0.52% return on the $125,000 in exactly three weeks — less any taxes, brokerage fees, and so on. You won’t pay much in fees if you stick with Interactive Brokers.

On June 19th, one of two things happens. The underlying stock will either trade above $52 or below $52. The latter option is preferable; in that situation the option expires worthless and the investor gets to keep that small premium. If South Bow trades above $52, then you’d be forced to sell at that price. This isn’t the end of the world, since you still get to keep the premium, and you’ve gotten a $2.40 profit on the shares themselves.

Where covered calls really get exciting is you can do the South Bow trade every month. A $0.26 per month premium multiplied by 12 months is $3.12. That’s a 6.24% yield.

Remember how we goosed the original investment’s yield by borrowing? We’re doing the same here. The 6.24% yield is on the $125k investment. It works out to additional income of $7,862 per year. If we express that as a percentage of the $100k original investment, it works out to a 7.86% yield.

Add the two yields together — 7.86% from the options plus 6.03% on the dividends — and we get a 13.89% yield. Subtract the cost of the leverage ($888 on $25k, or 0.889%) and you’re pretty much exactly at a 13% yield.

That’s the secret in less than 1,000 words. These portfolios are the product of leverage and options — with one little extra wrinkle we’ll get to in a second.

On the surface, covered calls seem pretty sweet. It’s a heads I win, tails I also win scenario. If the option is exercised and you’re forced to sell the stock, who cares? You’ve still made money.

The issue is these options cap your upside.

Say the Iran conflict flares back up again on June 17th and a bunch of oil production is taken offline. South Bow shares slowly moved up all month and then spiked as investors digested this new reality. They close at $55 each on the 19th.

The covered call writer made $2.40 per share in capital gains, plus the $0.26 per share in option premiums. It works out to $2.66 per share all together.

Not bad, except the person who did nothing but hold the stock made $5.40 per share. That’s more than double the profit of the covered call writer. And for less work, too.

This phenomenon is why covered call funds will often lag the underlying stocks in a bull market. Regular buy and hold investors get all the gains, while covered call writers regularly lose out on gains because they’ve capped their upside.

On the flip side, a covered call option can actually outperform during a flat or down market. Investors get those premiums and don’t have to sell because the underlying stock never hits the strike price. That’s the ideal situation for this strategy.

Except for one thing. Stocks tend to go up. The slowly grinding sideways ideal covered call market is the exception, not the rule.

There are all sorts of options gurus out there who claim to have strategies which solve the having to sell at the exact wrong time problem. I’m skeptical. My view is these strategies are essentially market timing strategies, which nobody can do with any consistency.

Like most other parts of the market, the option market is efficient. Boring stocks are less likely to move a whole bunch in a few weeks, making them ideal for a covered call investor. Except the market has long figured that out, so those stocks have small option premiums. Your yield on the strategy is much lower.

There’s one other wrinkle in the plan. If the underlying stock goes up and you’re forced to sell, that’s a taxable event. Unless, of course, those assets are held in your RRSP or TFSA.

These funds are well aware of this problem, and they’ve actually come up with fairly clever solutions. But not in a “holy cow, that’s smart” way, but in a “this is a little bit dishonest” way.

In a strong bull market — like the TSX for the better part of three years now — a covered call strategy will inevitably lead to the underlying stock getting called away.

In that scenario, the fund manager ends up with cash and no stock to write the next batch of covered calls with.

This is where things get tricky.

Ideally, the manager will take the capital, put it back to work, and repeat the covered call process again. In their defense, this is exactly what happens a lot of the time. Except the stock has gone higher than the strike price, and so they’re forced to buy in at an elevated price.

South Bow gets called away at $52, so the manager either buys back in at $55 or pivots to another stock.

But what often happens is gains don’t get invested. Say $50 of the $52 gets reinvested. The rest is used for:

These funds know that prospective investors only care about the yield. Therefore, they are motivated to make that monthly distribution as high as possible. They do that by taking some of the capital gains and repackaging them as distributions.

A common criticism of these funds is people saying “you’re getting your own money back.” This is how these funds do that.

The problem is it doesn’t take a fund manager to sell a stock and repackage it as income. Anybody can do that. That is the basis of every retirement plan that isn’t “I plan to live off the dividends.”

Hey, wait a minute. What happens to those yields during a bear market? When there are no gains from selling?"

It’s very simple. When a source of income goes away, it can’t be paid anymore. The leverage also isn’t your friend in a bear market. Distributions end up getting cut. There’s no other option. Any fund that pays back a portion of capital gains as distributions — and most of the leveraged ones do — will face this problem. It’s inevitable.

But until then, let the good times roll, baby!

Another criticism of these funds is they never beat the underlying stocks because covered calls cap the upside. As we discussed, it’s a problem.

But despite this handicap, and the issue of the management fee, a lot of these funds do end up beating a simple investment in the underlying stocks.

The reason why is very simple. It’s the leverage. A 125% bet on something will beat the 100% bet on something in a bull market — even if the 125% bet is an imperfect wager that has various costs attached to it. Stocks generally go up, so the leveraged bet usually wins.

It loses in a bear market, but we don’t talk about those anymore.

The better solution is to compare a 25% leveraged covered call ETF to a 25% leveraged position in the underlying stocks. When you do that, the winner will be the stocks themselves.

So if somebody compares BKCL or HMAX to ZEB, remember that they’re not making an apples to apples comparison. They must compare a leveraged product to a leveraged product.

Okay, let’s sum it all up. Here’s how you can create your own income fund, get your own double-digit yield, and save that management fee.

The yield you can generate from such a portfolio then depends on how you design it. A boring portfolio with covered calls and no leverage will yield in the ~7% range. Something a little friskier with no leverage gets up to ~9%. Boring with 25% leverage will give a yield that’ll creep into double digits. Spice things up with the 25% leverage and you’re looking at the 12-13% range.

Add a little bit of income generated by converting capital gains, and you’re looking at close to a 15% yield — provided the underlying stocks and the market cooperates.

But just remember one thing. Such a strategy will harm total returns. It caps gains. That’s the tradeoff one makes. I’d be reinvesting a big chunk of my income to try and make the whole pot bigger next year, but my view is I want my money to last for 40+ years. I need growth. Someone in their 70s likely has different goals.

Am I going to build such a product? No. Will I invest in such a thing? Hell no. I ain’t paying those fees, and I’m not very interested in leverage. I do not like the limited upside, either. But for some of you, maybe they’re the ticket. Hopefully y’all can make an informed choice after reading this.