A double-digit yield is always going to attract attention, especially when the distributions arrive every month. But with exchange-traded funds (ETFs), the first question I ask is where that income actually comes from.
A conventional dividend ETF mostly collects dividends from its underlying stocks and passes that income along to shareholders. Higher-yielding ETFs often need another source of cash flow. Covered calls are common, but there are other ways to generate option premiums.
One lesser-known example is the Moat Active Premium Yield ETF (TSX: MOAT). As of August 11, MOAT had a 12.2% annualized distribution yield and is paid monthly.
MOAT uses an actively managed portfolio alongside an options strategy, including cash-secured puts, to generate that income. I think the yield is interesting, but understanding the investment process behind it is more important.
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Getting paid to potentially buy stocks
The unusual part of MOAT is its use of cash-secured puts. Suppose the manager likes a company trading at $100 but thinks $90 would be a much better entry point. Instead of immediately buying the shares, the ETF can sell a put option with a $90 strike price and set aside enough cash to purchase the stock if necessary.
The ETF receives an option premium upfront. If the stock remains above $90 through expiration, the option can expire worthless and MOAT keeps the premium. If the shares fall below the strike price and the option is assigned, the fund purchases them for $90.
I think of it somewhat like getting paid to place a limit order. There is still downside risk. If that $100 stock crashes to $60, being obligated to purchase it for $90 is hardly a bargain anymore. The premium only provides a limited cushion.
Start with companies that have a moat
That’s why the stock-selection process matters so much. MOAT doesn’t indiscriminately sell puts on whichever stocks offer the highest option premiums, because some of these can be highly risky businesses.
The managers first look for high-quality businesses possessing what investors commonly call an economic moat, meaning a durable competitive advantage that can help protect profitability from competitors.
Morningstar’s well-known moat framework identifies potential advantages such as network effects, switching costs, intangible assets including brands and patents, cost advantages, and efficient scale.
MOAT does not track a Morningstar moat index or simply adopt that methodology. It is actively managed using a proprietary investment process. The underlying idea, however, is similar: identify companies that management believes possess durable competitive advantages, then pay close attention to valuation before establishing exposure.
That combination is particularly relevant when selling puts. The manager isn’t simply asking whether a company is good. It also has to determine a price at which owning the shares would be attractive if the option gets assigned.
Is the 12.2% yield worth it?
I wouldn’t buy MOAT solely because it currently yields 12.2%. Distribution yield is not the same as total return, and option premiums are not free money. Selling puts exchanges one set of risks for another, and MOAT can lose money when its underlying investments decline.
There is also active-management risk. You’re relying on the managers to correctly identify durable businesses, value them appropriately, and implement the options strategy effectively.
But I think MOAT is more interesting than many high-yield ETFs built around simply maximizing option premiums on volatile stocks. There is at least a coherent investment philosophy underneath the payout: find quality businesses, wait for attractive valuations, and use options to generate income while doing so.
For investors who understand those trade-offs and prioritize monthly income, I think MOAT is worth a closer look. I just wouldn’t mistake its 12.2% distribution yield for a guaranteed 12.2% investment return.
