This ETF’s 6.8% dividend yield looks very appealing, but it conceals several risks for investors.

The fund’s currency hedging only favours investors under certain conditions, and the ETF’s need to buy covered call options can run up brokerage commissions and diminish overall returns.

COVERED CALL HEDGED BMO EUROPE HIGH DIVIDEND TO CAD ETF (symbol ZWE on Toronto; www.bmo.com/gam/ca/investor/products/etfs) holds mostly high-quality European stocks. These include Swiss Re AG, HSBC Holdings plc, Zurich Insurance Group, BMW, Total SA, Teliasonera AG, BP plc, Allianz SE, Imperial Brands plc and Nordea Bank AB.

The ETF is reasonably well-balanced across the five economic sectors. It’s also focused on more-stable European countries, with 25.4% of its assets in the U.K., 24.4% in Switzerland, 20.3% in France, 16.5% in Germany, 4.1% in Sweden, 3.7% in Finland, 3.5% in Belgium and 2.3% in the Netherlands.

In general, a substantial portion of the ETF’s foreign currency exposure is hedged against the movement of the euro, Swiss franc, pound and so on against the Canadian dollar. That means for the most part the ETF’s Canadian-dollar value rises and falls solely with the movements of the stocks in its portfolio.

Expenses on the units are 0.65% of assets, excluding the cost of currency hedges. The cost of hedging can go up and down and is independent of the positive impact hedging may have on your portfolio.

ETFs: Dividend income insufficient to cover high yield

Hedging against changes in European currencies only works in your favour when the value of those currencies drops, compared to the Canadian dollar. If on the other hand, the European currencies rise while your investment is hedged, hedging reduces any gain you’d otherwise enjoy (or expands any loss you’d suffer).

We see foreign currency exposure as a long-term plus—a valuable form of diversification. If you are wary of the possibility of a decline in European currencies, our advice is to reduce your exposure to European stocks and other European currency assets. There are no bargains in the market for foreign-currency hedges.

BMO Europe High Dividend Covered Call Hedged to CAD ETF yields a very high 6.8%. However, the dividend income that the company receives from its portfolio is insufficient to cover so high a dividend yield. To make up the difference, the ETF has to make a profit on trading its portfolio. It also aims to raise its returns by writing call options on the portfolio’s securities.

Selling call options generates a stream of income for this ETF. However, its options dealings generate a lot of brokerage commissions, which eat away at the fund’s capital. More important, selling calls also tends to diminish any capital gains that its portfolio might generate.

When stocks the fund owns go up, holders of its call options will exercise their right to buy the stock at the agreed-upon lower price. Meanwhile, the fund will want to hold on to its losers—stocks it owns that are going down—to satisfy any call options it has sold on those stocks. This introduces a filtering mechanism that hurts long-term results.

We advise against investing in ETFs that try to generate income by dabbling in options.

TSI Network recommendation: We don’t recommend the BMO Europe High Dividend Covered Call Hedged to CAD ETF.

For our advice on how to make the right choices amid the growing number of ETFs, read The Best Performing ETFs provide ways to profit in rising markets.

For our recent report on a better way to hold bonds today, read Two ETFs may be the best choices in bonds.