ETF Dividend Dilemma

I have written before that one flaw with investing in ETFs is that dividend yields can be less that of individual stocks. This pertains to sectors that usually pay high dividends like utilities and financials among others.

Unfortunately my idea will only be useful if you have a very large account, but don't want to deal with trying to buy individual stocks.

Quick editorial for new readers: I believe if you have an account that is at least $150,000 to $200,000 you should have the equity portion of your portfolio in individual stocks, at least some anyway.

You may be able to replicate a dividend yield by selling covered calls against some of the ETFs. I'll cite some examples with ETFs that I do not own personally or for clients. The reason why I say this will only work with larger accounts is that commissions may get in the way of selling one or two call options.

The way I am approaching this is to create a dividend not sell close to the money calls trying to make 5% a month, please keep that in mind. As a dividend proxy, I think it makes sense to try to sell calls two or three times a year.

First I'll look at the Financial SPDR (XLF) which closed Tuesday at $30.21. XLF already has a
2.05% yield. The June 33 call was bid at $0.15 at the close on Tuesday. The options are a little more than 9% out of the money and expire in five months. On 1000 shares you bring in $140 net of commissions. Do that twice a year and you add almost 100 basis points to the yield. The risk is that XLF goes up by more than 9% by June and you would leave money on the table. If the market is flat, as I believe it will be, basis points will matter.

Next lets look at the Basic Materials SPDR (XLB). XLB closed Tuesday at $29.03 and has a yield of 1.7%. The June 32 calls closed with a bid of $0.20. This trade is very similar to XLF, you are potentially adding 130 basis points to the yield if you can get the trade done twice in a year.

Lastly the Utilities SPDR (XLU); XLU closed Tuesday at $27.79 and has a yield of 3.14%. The June 29 call options (there are no 30s for June) were bid at $0.35. This might add an extra 2.5% in yield but the options are very close to the money. If you have any interest in this trade it may make sense to only cover a portion of the position.

One thing that looms in the distance for this type of trade is that if/when interest rates go up option premiums might then go up too. Every options pricing model I have ever heard of uses some sort of short term interest rate in its calculations. Higher interest rates, everything else being equal, results in higher premiums. Of course everything else being equal isn't reality.

You may or may not be able to do these trades as described because the market may move in either direction making them less attractive. The point of the article is to think about different ways to manage your portfolio. This type of trade is not right for everyone but there is no reason not to learn about it so you can make an informed decision about various tools available.