Pat McKeough recently responded to an Inner Circle Member interested in his opinion of an ETF that covers big U.S. tech stocks, uses covered call options to raise income and hedges against movements in the U.S. dollar. Pat explains the complexities of the ETF and points out that hedging requires extra fees and a rising U.S. dollar can hurt investors several ways.

Q: Pat: Could you share your views on the First Asset Tech Giants Covered Call ETF? Regards.

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A: FIRST ASSET TECH GIANTS COVERED CALL ETF (CAD HEDGED) (symbol TXF on Toronto; www.firstasset.com) invests in what it sees as some of the largest and most innovative U.S. technology companies. The largest 25 tech stocks listed on New York or Nasdaq, measured by market capitalization, are chosen for inclusion in the ETF on an equally weighted basis. They are rebalanced quarterly.

The $168.6 million ETF started up on October 24, 2011, and has a 0.65% MER. First Asset is owned by C.I. Financial.

The ETF’s top holdings include Micron Technology, HP Inc., Corning, Intel, Applied Materials, Facebook, Microsoft, Yahoo, Adobe Systems, Salesforce.com, Cisco Systems, Alphabet, Intuit Inc., Nvidia and Qualcomm.

First Asset Tech Giants has a high 4.6% yield. However, the ETF’s portfolio does not provide enough dividend income to cover the fund’s management expenses and fees, plus that high yield. To make up the difference, it has to make capital gains by trading the portfolio’s securities. It also aims to raise its returns by writing call options on the portfolio’s securities.

Selling call options generates an income stream for First Asset Tech Giants. However, selling calls also tends to diminish any capital gains that its portfolio might generate. When the stocks that the ETF owns go up, holders of the call options it has sold will exercise those options and buy the stock at the price fixed by the option’s terms. Meanwhile, First Asset Tech Giants will want to hold on to its losers—stocks it owns that are going down—to offset its obligations under the call options that it has sold.

ETFs: Rise in U.S. dollar can reduce gains, or expand a loss

The managers of First Asset Tech Giants’ portfolio aim to keep each of their 25 holdings in the range of 4% of the portfolio’s overall value. That means they will need to rebalance the portfolio’s holdings each quarter. This selling and buying also generates commission expenses.

Hedged ETFs are ETFs sold in Canada and that hold U.S. stocks. However, they hedge against any movements of the U.S. dollar against the Canadian dollar. That means that the ETF’s Canadian-dollar value rises and falls solely with the movements of the stocks in its portfolio.

For example, if a stock rises 10% on, say, New York, and rises another 5% for Canadian investors because of an increase in the U.S. dollar, a holder of a hedged ETF would only see a 10% rise in the value of that holding. The reverse is also true, and if the U.S. dollar were to fall 5%, investors would still see a 10% rise.

However, hedged funds include extra fees to pay for the hedging contracts needed to factor out currency movements.

Of course, the cost of hedging can rise or fall, and cost changes are unrelated to the effect the hedging has on your portfolio. Hedging against changes in the U.S. dollar only works in your favour when the value of the U.S. dollar drops in relation to the Canadian currency. If the U.S. dollar rises while your investment is hedged, it reduces any gain you’d otherwise enjoy, or expands a loss.

Some investors have mixed feeling today about investing in U.S. indexes such as the S&P 500 or Nasdaq 100. They may have a high opinion of many of the major multinational companies in those indexes. But they may also fear the U.S. dollar has gone too high in the past few years and is at risk of a downturn. So hedged ETFs may have some appeal.

However, we see U.S. dollar exposure as a long-term plus—a valuable form of diversification. If you are 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.

Inner Circle recommendation: We don’t recommend the First Asset Tech Giants Covered Call ETF (CAD Hedged).

For our views on the most successful approach to investing in ETFs, read Discover the best Canadian ETFs with these 5 tips.

For our recent report on two leading global ETFs, read Two ETFs surge with the rise in emerging markets.

This article was originally published in 2017 and is regularly updated.