This Monthly Income ETF Yields 12%, and Every Canadian Should Take Note

When you see an investment yielding somewhere between 8% and 12%, your first reaction should usually be caution. For individual stocks, yields that high can sometimes signal trouble.

Even industries known for generous payouts rarely sustain yields at that level without some underlying stress. A dividend that looks attractive on the surface can sometimes be a warning sign that investors expect the payout to be cut.

Exchange-traded funds (ETFs) are a little different. Some ETFs can generate unusually high yields because of the strategies they use. Two of the most common tools are covered calls and leverage.

Covered calls involve selling options on stocks already held in the portfolio. This strategy brings in extra income, though it does limit how much the underlying shares can rise in price. Leverage works differently. It allows the fund to borrow money and invest more than the capital investors originally contributed. That can increase both potential income and potential losses.

A handful of ETFs combine both approaches to push yields into double-digit territory. One of the more prominent examples is Harvest Diversified Monthly Income ETF (TSX:HDIF). As of March 12, this ETF offers a yield of about 12.44% and, as the name suggests, pays distributions every month.

HDIF has also attracted significant investor interest, with roughly $475 million in assets under management. Here’s what investors should understand about how this ETF works before buying it.

What is HDIF?

HDIF is structured as what’s known as a fund of funds. Instead of holding individual stocks directly, the ETF invests in a portfolio of other Harvest ETFs.

Many of those underlying funds focus on specific sectors of the market, including information technology, utilities, U.S. banks, industrials, consumer staples, and travel and leisure companies.

Each of those ETFs generally employs a covered call strategy. In most cases, options are sold on up to about 33% of the underlying portfolio. The result is a diversified portfolio of sector ETFs that are all designed to produce income.

This approach leaves roughly two-thirds of the portfolio free to participate in stock price gains while generating additional income from option premiums. The trade-off is that part of the upside is capped in exchange for higher cash flow.

HDIF structural enhancements

HDIF goes one step further than simply holding these income-focused ETFs. Harvest actively manages the allocation among the underlying funds, adjusting the weight of each sector depending on market conditions.

More importantly, the ETF also applies leverage at the portfolio level. Specifically, the fund uses approximately 1.25 times leverage. That means for every dollar invested by shareholders, the ETF borrows an additional $0.25 to increase its exposure to the underlying ETFs.

In practical terms, the portfolio behaves more like 125% equity exposure rather than a standard 100% stock allocation. This leverage helps boost the overall income generated by the portfolio, which contributes to the ETF’s current distribution yield of about 12.44%.

However, leverage also increases risk. In a declining market, losses can be amplified. Investors should remember that if a traditional equity ETF falls 10%, a leveraged portfolio could experience a larger decline.

For investors comfortable with the mechanics of covered calls and moderate leverage, this structure can produce very high income. But it is important to understand the trade-offs before relying on it as a long-term core holding.

The post This Monthly Income ETF Yields 12%, and Every Canadian Should Take Note appeared first on The Motley Fool Canada.

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More reading

• The Best Stocks to Invest $1,000 in This March
• Canadians: How Much Should Be in a 20-Year-Old’s TFSA to Retire?
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• TSX Today: What to Watch for in Stocks on Thursday, March 26
• 5 TSX Dividend Stocks Yielding 2.9% to 6.2% for Steady Cash Flow in Any Market

Fool contributor Tony Dong has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.