If you’re trying to generate more income from a portfolio, buying conventional dividend stocks is only one approach. You can target pass-through entities such as real estate investment trusts (REITs) or income trusts, use leverage to increase exposure, or sell options to generate additional premiums.
For that last strategy, covered calls are by far the most common approach among Canadian exchange-traded funds (ETFs). A covered call involves owning a stock and selling a call option against it. You collect the option premium upfront, but potentially give up some upside if the stock rises above the option’s strike price.
Cash-secured puts work differently. Instead of already owning the stock, you sell a put option while setting aside enough cash to buy the shares if assigned. You still collect an option premium, but you are taking on the obligation to purchase the stock at a predetermined price if it falls sufficiently.
Only a handful of Canadian ETFs make meaningful use of this strategy. One that remains relatively under the radar is the Moat Active Premium Yield ETF (TSX: MOAT), which offered a 12.17% annualized distribution yield as of August 11. Here’s what you need to know before chasing that yield.
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How MOAT works
MOAT starts with active stock selection. As its name suggests, the portfolio managers look for companies possessing an economic “moat,” or a durable competitive advantage that can help protect profitability from competitors over long periods.
Morningstar’s well-known economic moat framework identifies several potential sources of these advantages. These include intangible assets such as valuable brands or patents, switching costs that make it difficult for customers to leave, network effects where a product becomes more useful as more people adopt it, cost advantages, and efficient scale in markets that can only support a limited number of profitable competitors.
MOAT does not simply follow Morningstar’s framework or track one of its moat indexes, though. This is an actively managed ETF using its own proprietary process to identify companies with durable competitive advantages across the Canadian and U.S. markets.
That distinction matters because MOAT’s managers have discretion over which companies qualify, their valuations, and ultimately which opportunities make it into the portfolio.
Getting paid to wait for a better price
Finding a great company is only half the equation. You can identify a business with an exceptional competitive advantage and still earn disappointing returns if you pay too much for its shares. This is where MOAT’s cash-secured put strategy becomes interesting.
Suppose a wide-moat stock trades for $100, but the manager would be comfortable buying it at $90. Rather than immediately purchasing shares, MOAT can sell a put option with a $90 strike price while keeping sufficient cash available to cover a potential assignment.
Think of it somewhat like getting paid to place a limit order. If the stock remains above $90 through expiration, the option expires worthless, and MOAT keeps the premium. The fund can then repeat the process.
If the stock falls below the strike and MOAT is assigned, it purchases the shares at $90. The option premium received also effectively reduces the economic purchase price further.
There is no free lunch, of course. If that $100 stock collapses to $60, MOAT could still be obligated to purchase it for $90. The premium provides only a limited cushion against losses. The strategy therefore depends heavily on the manager being right about both business quality and valuation.
For investors comfortable with those risks, MOAT provides an unusual way to outsource a cash-secured put strategy while receiving monthly distributions. Its 12.17% annualized distribution yield is certainly eye-catching, but the quality of the underlying investments and sustainability of the strategy matter far more than the headline payout.
