This ETF’s focus on top tech stocks and its 5.3% dividend yield have appeal, but they come at a cost.  

In order to maintain its dividend, the fund must trade securities and place call options, both of which drain its capital. What’s more, the fund’s Canadian currency hedging only benefits investors in certain circumstances, and runs up additional costs.

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

The $168.6 million ETF started up on October 24, 2011, and has a relatively high 0.65% MER. C.I. Financial owns the fund.

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

First Asset Tech Giants has a high 5.3% yield. However, the ETF’s portfolio does not provide enough dividend income to cover the fund’s management expenses and fees, plus its own high dividend to unitholders. To make up the difference, the fund’s managers trade the portfolio’s securities for capital gains. They also aim to raise its returns by writing call options on those securities.

Selling call options generates an income stream for First Asset Tech Giants. However, options trading also tends to generate a lot of brokerage commissions that eat away at capital. Selling calls also tends to diminish any capital gains that the ETF’s portfolio might generate. When the stocks that it owns go up, holders of its call options will exercise their right to buy the stock at the fixed price. 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 existing call options.

ETFs: Need to rebalance holdings each quarter raises fund’s expenses

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

Hedged ETFs like this one invest in U.S. stocks, but “hedge” against any movements in the U.S. dollar, using derivatives. That means that the ETF’s Canadian-dollar value rises and falls solely with the movements of the stocks in its portfolio, but is not directly affected by changes in the foreign exchange rate between the U.S. and Canadian dollars.

For example, if a stock listed on New York, for example, gains 10% and gains another 5% for Canadian investors because of a rise 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 their hedging activity.

Of course, the cost of hedging can rise or fall, and cost changes are unrelated to the effect the hedging has on the portfolio. Hedging against changes in the U.S. dollar only works in this ETF’s favour when the value of the U.S. dollar drops in relation to the Canadian dollar. If the U.S. dollar rises, it reduces any gain investors would otherwise enjoy, or expands any loss.

In today’s market, some investors have mixed feelings about investing in U.S. indexes such as the S&P 500 or Nasdaq 100. While they may value the major multinational companies in those indexes, they may also be afraid that the U.S. dollar has gone too high in the past few years and is at risk of a downturn. Hedged ETFs may, therefore, 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.

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

For our advice on how to make the best choices amid the growing number of ETFs, read The Best Performing ETFs help you maximize your portfolio profits.

For our recent report on another covered call ETF, read This ETF’s high yield comes with higher risk.