The monthly income ETF paying 10% from stocks that yield under 2%

How can an ETF produce a monthly income that equates to 10% per year despite having a dividend yield of less than 2%?

Traditionally, if you are looking for a high-dividend or high-income ETF, you would be looking for a portfolio filled with companies that have high dividend yields. Even then, many of these ETFs will provide a yield of maybe 5%.

But Canada’s Harvest Healthcare Leaders Income ETF (TSX:HHL) is different.

The average dividend yield for this portfolio is only 1.49%. Yet, thanks to clever management, it has been paying out almost 10% per year to investors.

Is this a high-yield dividend ETF?

The Harvest Healthcare Leaders Income ETF is not your typical high-yield dividend ETF.

Rather than a portfolio of large, mature companies that pay large dividends because they don’t need much cash for growth, the portfolio is actually made up of some of the largest and most innovative names in healthcare.

These are not income-oriented companies. If anything, they skew towards growth.

Instead of providing income to investors through dividends, it utilises a different method. Distributions are generated from a combination of dividends, covered call premiums and sometimes capital returns. Because of this, rather than being called a “high-dividend ETF”, it is arguably better described as a thematic “monthly income ETF”, given that the fund pays distributions monthly.

How does the ETF generate monthly income?

The secret to how the Harvest Healthcare Leaders Income ETF has been able to turn a 1.49% dividend yield into a 10% annualised payment is in how it is able to extract extra income from using covered calls.

A call option is where the seller (in this case the Harvest ETF) owns shares in a company and offers the buyer the option, but not obligation, to buy shares at a predetermined price. In exchange for this opportunity, the buyer will pay the seller a premium. Harvest will collect these premiums and add them to dividends received to boost the amount of cash it can pay out to investors.

Of course, if the share price of a company rises above the option price, the investor may choose to exercise the option, and Harvest will need to sell those shares at the agreed price and miss out on any further potential upside.

While the option premium provides some income when markets fall, this cushion is limited. If healthcare stocks fall sharply, the portfolio will still fall with them. The strategy can also impact upside, as when prices rise sharply, the call options might be exercised, meaning that the portfolio doesn’t benefit as much from that rise.

This activity of harvesting additional monthly income from options is why the fund's management fee of 0.95% is above that of your average index fund, as it requires significantly more active management.

Most followed narrative on Simply Wall St for HHL

The most followed narrative on the Simply Wall St community for the Harvest Healthcare Leaders Income ETF goes beyond just looking at the mechanics of its distributions.

Its core investment thesis is that the ETF provides exposure to 20 large-cap healthcare leaders, who are benefiting from numerous structural tailwinds such as an aging population, rising healthcare spending and continued innovation across pharmaceuticals and medical technology, while using covered calls to turn part of the portfolio’s potential upside into regular income.

For investors wanting to go beyond the question of where the ETF’s income comes from, the full narrative provides a deeper dive into the ETF, including its valuation, covered-call strategy, peer comparison and key risks.

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Simply Wall St analyst Andrew Legget and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.