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Technology stocks hold the promise of exposure to paradigm-changing areas of innovation such as AI, VR and AR, and the metaverse. However, the sector can also be volatile, and it has faced the same headwinds as the rest of the equity market in the past year. As a result, many investors are steering clear of it.

Depending on their risk tolerance, investors may want to reconsider, says James Learmonth, senior portfolio manager at Harvest ETFs. He’s part of the team that manages the Harvest Tech Achievers Growth and Income ETF (HTA:TSX), which invests in 20 equally weighted tech companies with a minimum market capitalization of US$10 billion that trade on a North American exchange. Holdings in HTA must be traded in an active options market, because what sets the HTA ETF apart from a core tech portfolios is that its complemented by an active covered call strategy.

“Writing call options on the portfolio gives investors a way to monetize some of that volatility and generate cash flow to meet their investment objectives from an income perspective—while still remaining invested in large-cap technology companies and exposed to any potential upside in the future,” Learmonth explains. “This kind of environment is where a covered call strategy like ours can provide additional value for investors.”

A challenging year for all stocks

“As all equities came to terms with rising interest rates this year, growth stocks experienced multiple compressions, and investors started to put a higher discount rate on future earnings for growth companies, including those in the tech sector”. says Learmonth.

“As we moved through the year, we started to see pretty dramatic slowing of global economic growth from the general hangover of the pandemic-era monetary and fiscal stimulus. That has started to impact the growth outlook for companies in general,” he adds.

The pandemic initially boosted tech sales as people upgraded for remote work. However, the return to in-person work led to decreased demand for home office setups, causing a shift in tech company strategies. They adapted by focusing on hybrid work solutions and innovations to suit evolving needs.

Of course, not all companies have experienced the pullback equally. “A dichotomy exists between established tech companies and earlier-stage technology companies,” says Learmonth. “More of [the latter’s] valuations are dependent on future prospects that, in many cases, they haven’t realized yet.…Established companies with strong operating models are revenue-, earnings-, and cash flow-positive, [and so] you’ve seen more established companies holding up relatively better.”

Established companies well positioned for future growth.

Learmonth adds that established companies, with their strong balance sheets, have been able to invest through the downturn, so they’re well positioned for an upswing. That’s in contrast to earlier-stage companies that are often more dependent on external funding and can’t invest—or can’t invest as much—all the way through the economic cycle.

Looking to the future, Learmonth says a number of macroeconomic trends make tech an attractive place for investors to be. Several themes—digitization of the consumer, the shift to cloud-based infrastructure, AI, VR and AR, and the ubiquitous need for cybersecurity—stand to drive continued investment in technology into the future. Investors who are comfortable with a few ups and downs have an opportunity to participate in significant potential growth.

“We’re looking for companies that have grown to the point where they’re the dominant players or leaders in the end markets they serve,” Learmonth emphasizes. “We want to build a diversified portfolio within the technology sector. Then, from there, we overlay our active covered call strategy to enhance the underlying dividend yield of the portfolio and offer a higher yield to investors.”

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Healthcare is vastly underrepresented in Canadian equity markets, comprising just 0.30% of the S&P Composite Index on July 31, 2023.[1] In contrast, healthcare made up 12.79% of the MSCI World Index on the same date.[2] So, Canadian investors have to look outside of our borders to get exposure to a sector with relatively short-term defensive characteristics and long-term growth potential that can add valuable diversification to an equity portfolio.

“Healthcare is a massive global industry that has positive structural long-term tailwinds,” says Paul MacDonald, chief investment officer and portfolio manager at Harvest Portfolios Group. “You’ve got permanent, non-cyclical drivers impacting the long-term growth for the sector.”

Three primary drivers, MacDonald explains, are aging populations, technological innovation, and developing markets. As people age, they spend more on healthcare. Technological innovation is creating rapid advances in areas such as medical devices and both small-molecule and biologic drugs. And healthcare expenditures are rising as wealth increases in developing markets.

Meanwhile, in a macro environment with challenging shorter-term market dynamics, as central banks increase interest rates to rein in high inflation, healthcare may provide partial shelter from the storm. That’s because many of the businesses in the sector often have high margins and low exposure to commodities while producing a “superior good” that’s needed in up and down markets.

Total returns matter more than ever

Cash flow, too, can provide a buffer in the face of a difficult market outlook. In fact, it’s at times like these that cash flow becomes a more important component of total return. This makes a solution such as the Harvest Healthcare Leaders Income ETF attractive to more than just investors seeking exposure to healthcare with a high level of cash flow, MacDonald suggests.

His team chooses 20 equally weighted large-cap healthcare companies for the ETF and then layers on a covered call strategy to enhance cash flow. The options give up a little of the upside of stock performance in return for higher current monthly cash flows. As of July 31, 2023, the ETF’s yield was 8.69%[3].

The companies in the ETF are selected based on a quantitative screen that narrows the universe of global healthcare companies to about 85 U.S.-listed companies offering options.

“We peel back the layers on each one of these companies to build a portfolio of 20, making sure that we’re diversified across each one of the healthcare subsectors,” MacDonald says. “We go through that process quarterly, but turnover tends to be fairly low, just given the front-end analytics we put into picking our 20 companies.”

In the end, investors get access to a sector focused on creating products with real-world applications that change people’s lives. MacDonald points, for example, to exciting developments in robotic-assisted surgery and personalized drugs. He also likes the fact that pharmaceutical firms, in particular, are now pivoting from a pandemic focus back to more normalized business lines and research & development productivity.

At the same time, because of its high yield, the Harvest Healthcare Leaders Income ETF has the potential to generate total returns higher than the broader equity market can deliver right now.

“We provide that monthly, steady cash flow, [and], even if one is not looking specifically for that…given the relative opportunities elsewhere, the covered call strategy can add to that overall total return,” MacDonald says.

¹ www.spglobal.com/spdji/en/indices/equity/sp-tsx-composite-index/#overview (see Factsheet) ² www.msci.com/documents/10199/178e6643-6ae6-47b9-82be-e1fc565ededb ³ https://harvestportfolios.com/etf/hhl/

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It hasn’t been easy to generate cash flow from investments lately. Rising interest rates have had an impact on fixed income assets, while inflationary pressures have compressed real returns. At the same time, volatility has hit equities, including those paying dividends.

Paul MacDonald oversees an approach that has been providing investors with a relatively high level of income through these challenging markets. MacDonald is chief investment officer and a portfolio manager at Harvest ETFs, and his team runs eight sector-specific equity income exchange-traded funds (ETFs), plus the Harvest Diversified Monthly Income ETF (HDIF), which holds seven of the others with no additional management fee.

Each of these equity income ETFs benefits from a focus on areas of the market with a record of long-term growth. Within sectors, the team seeks out good-quality businesses that have proven they can adapt to changing environments. Meanwhile, security selection is complemented by an actively managed covered call strategy applied to up to 33% of each portfolio. Current yields, as at July 31, 2023, ranged between 7.38% and 9.06%.

“With covered calls, there’s a trade-off. You forego some of the upside in favour of current high cash flow,” MacDonald explains. “We’re participating in the longer-term growth of our underlying businesses…and, at the same time, we’re able to generate really consistent, steady, tax-efficient monthly cash flows.”

Covered calls capitalize on volatility

Covered calls generate income by selling options on positions in the portfolio. They’re best applied to holdings that are unlikely to move up or down very much during the life of the option. Harvest’s active approach examines every portfolio, and every security within it, on a monthly basis to determine what and how much to write within the 33% limit.

MacDonald emphasizes that this active overlay is critical when markets are volatile. After all, one of the key drivers of option pricing is volatility, so it is precisely in this type of environment that his team can monetize more cash flows.

To enhance its distribution yield, Harvest’s multi-sector ETF HDIF incorporates 25% leverage. As of July 31, it had attracted more than $344.5 million in assets.

“The leverage used in HDIF allows us to enhance the income generation of the underlying ETFs it holds by 25%…for those who are looking for a little bit more torque on their income, over and above the core ETF,” MacDonald says. “For every $100 invested, this ETF is generating cash flow on $125.”

HDIF provides advisors with an additional option to deliver the regular stream of inflation-beating monthly income their clients need.

Source: https://harvestportfolios.com/wp-content/uploads/why_invest/Harvest_investment_products_web_pdf.pdf