A Member of Pat McKeough’s Inner Circle recently asked for his advice on a healthcare fund that engages in covered call option writing and similar trading activities.

Pat likes the stocks held by the fund and its high yield. However, he feels the drawbacks of the call option strategy outweigh the benefits, and the fund’s performance over time will likely suffer.

Evolve Global Healthcare Enhanced Yield Fund (Symbol LIFE on Toronto; www.evolveetfs.com), aims to track the Solactive Global Healthcare 20 Index Canadian Dollar Hedged Index.

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LIFE invests primarily in the stock holdings of that index. The fund also writes covered call options on up to 33% of its portfolio securities. Note, the level of covered call option writing may vary based on the fund managers’ analysis of market volatility and other factors.

The ETF launched on October 25, 2017. Its MER is 0.45%.

The fund holds 20 equally weighted stocks. They include Thermo Fisher Scientific, Pfizer, Zoetis, Novartis AG, Roche Holding Eli Lilly, AstraZeneca, AbbVie, Danaher Corp. and GlaxoSmithKline.

We have a favourable opinion of some of the stocks that the ETF holds, and its yield is very high at 7.3%. However, the ETF may find it difficult to maintain that payout.

That’s because the dividend income from LIFE’s portfolio falls short of the fund’s cash demands—to pay distributions to its unitholders and cover its own management expenses and fees. To make up the difference, the fund attempts to trade the portfolio’s securities for capital gains. It also tries to raise its returns by “writing” (selling) call options on its holdings. Both these fund-raising activities can backfire.

Inner Circle: Why we don’t like selling options as a strategy

Selling call options generates an income stream. However, selling calls also tends to diminish any capital gains that the ETF’s portfolio might generate.

When the stocks that the fund owns go up, holders of the call options it has sold will exercise their options and buy the stock from the company at the earlier, lower price set out in the option terms. Meanwhile, LIFE will need to hold on to its losers—stocks it owns that stagnate or fall—to offset any future obligations under the call options it has sold.

Win or lose, options trading tends to generate a lot of brokerage commissions that eat away at the fund’s capital.

Meantime, the Canadian-dollar ETF hedges against movements of the U.S. dollar (and other currencies if needed). That means its value rises and falls solely with the movements of the stocks in its portfolio.

Of course, the cost of hedging can rise or fall, and there’s no guarantee of a favourable impact on the portfolio. Hedging against changes in the U.S. dollar works in your favour when the value of the U.S. dollar drops against the Canadian dollar. If the U.S. dollar rises while your investment is hedged, it reduces any gain you would have otherwise enjoyed, or produces a loss.

Some investors may fear the U.S. dollar is at risk of a significant downturn. So, the hedging aspect of this ETF may have some superficial appeal for them. However, we see U.S. dollar exposure as a long-term plus—a valuable form of diversification.

If you’re wary of the possibility of a U.S. dollar decline, our advice is to reduce your exposure to U.S. stocks and other U.S. dollar assets. There are no bargains in the market for foreign-currency hedges.

Recommendation in Pat’s Inner Circle: Evolve Global Healthcare Enhanced Yield Fund is not recommended.