I love Canadian bank stocks. Our country’s banking industry, dominated by the “Big Six” — Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia), Bank of Montreal, Canadian Imperial Bank of Commerce, and National Bank of Canada — presents a unique investment proposition, thanks to its oligopolistic structure, strong regulations, and a historical tendency towards consistently increasing dividends.
The oligopolistic nature of the industry offers significant barriers to entry, allowing these big banks to maintain a firm grip on their market shares and deliver consistent profits. On the regulatory front, Canada’s stringent rules ensure that our banks are well capitalized and manage risk prudently, which promotes overall financial system stability. Finally, these banks have a long-standing tradition of not only paying dividends but also growing them over time — a boon for income-focused investors.
Convinced? Here’s a spin — I wouldn’t buy individual bank stocks. Instead, I’d rather use an exchange-traded fund (ETF) that provides diversified exposure to a few. Here are my top two picks.
ZEB: An equal-weight powerhouse
When discussing ETFs that provide exposure to Canadian banks, one can hardly overlook BMO Equal Weight Banks Index ETF (TSX:ZEB). This ETF presents a simple yet effective way for investors to gain exposure to the Big Six banks in one convenient package.
ZEB follows an equal-weight strategy, meaning it allocates roughly the same amount of its portfolio to each of the six major Canadian banks. This approach ensures no single bank dominates the portfolio, thus promoting diversification. If one bank encounters difficulties, the balanced weighting helps mitigate the potential negative impact on the ETF’s overall performance.
The benefit of investing in ZEB is twofold. Firstly, you gain exposure to the steady, long-term growth potential and robust dividends of Canada’s banking sector. Secondly, this fund essentially does the work for you by managing and rebalancing the holdings, saving you from the complex decision-making process of which banks to buy, when to buy, and how much to allocate to each.
As of July 2023, ZEB has a handsome distribution yield of 5% paid monthly — a key feature for income-focused investors. Its management expense ratio (MER) is 0.28%, which, while higher than some passive index funds, is not unreasonable considering the convenience and exposure it provides.
ZWB: A yield juggernaut
For investors seeking an enhanced income stream from Canadian banks, BMO Covered Call Canadian Banks ETF (TSX:ZWB) might be a perfect match. Like ZEB, this ETF also provides exposure to the Big Six banks. However, ZWB employs a covered call strategy, adding an extra layer of income generation on top of the dividends offered by the banks.
A covered call is an options strategy where the fund sells call options on its holdings. In simple terms, for collecting a premium upfront, the fund gives someone else the right to buy its stocks at a predetermined price within a certain period. If the banks’ shares don’t rise above this price, the fund keeps the premium, boosting its income. This approach can generate additional cash flow, particularly in flat markets
The tradeoff, however, is that the fund may miss out on some upside if the banks’ shares surge beyond the strike price of the call options. Hence, ZWB might underperform its peers in a strongly bullish market. Overall, you get less capital appreciation with a covered call ETF like ZWB, making them most suitable for yield-hungry investors looking for income.
As of July 2023, ZWB offers a distribution yield of 7.45% paid monthly, which is higher than ZEB due to the income from selling call options. That being said, it charges a higher MER of 0.71%, reflecting the higher costs involved with the covered call strategy.
