With bonds yielding so little, the income portion of many portfolios has been the first to suffer. To compensate, investors have reached out to less traditional sources of portfolio income, including derivative strategy ETFs and MLP ETFs, but have we gone too far?
Three signs say yes:
- Asset growth in income-producing ETFs
- Income-focused ETF launches
- Unlikely sources of yield
Many investors, especially retirees, depend on the income portion of their portfolio to provide the intermittent cash flows to fund expenditures. The policies pursued by the Federal Reserve have suppressed the yields on most fixed-income instruments to ultra-low rates, which has left many investors with insufficient cash flows.
To compensate, some investor portfolios have shifted to alternative forms of income or, rather, ETFs that happen to have high dividend yields. These include business development and private equity ETFs, derivative strategy ETFs, real estate ETFs and MLP ETFs, to name a few.
The need for cash flow is real and significant. ETF issuers have taken notice and are increasingly pitching their products as solutions. Take SLVO, for example, whose popular banner advertisements tout the product as “an opportunity for monthly cash flow.”
This has helped drive asset growth in these income-producing segments of the market, which leads me to my first sign that we may have gone too far.
1) Asset Growth
To identify 50 ETFs investors would be most drawn to for yield, I ranked all U.S.-listed ETFs by the trailing 12-month dividend yield that their underlying constituents would have contributed to the fund (note that this is not necessarily the yield that the fund actually distributed).
I then compared the assets under management growth in those funds to the AUM growth in the rest of the ETF market. The results:
The quest for yield is evident in this table:The “top-50” group saw AUM grow at three times the rate of the rest of the ETF market.
One could argue that the growth in AUM could be performance driven, as opposed to new assets allocated to those funds. However, my best estimates stake performance as responsible for only about one-fifth of the asset growth in the group titled “Top 50.”
The fact that AUM growth in the highest-yielding portfolios has outpaced the rest of the ETF market by three times could suggest the presence of a bubble in the “high-yield”/“anything income” market segments.
In the quest for yield, a disproportionate amount of assets have flowed to these securities and have potentially driven prices to lofty heights, which could prove dangerous if assets rotate back to traditional fixed income when rates are reasonable.
2) Product Launches
The second sign that we may have gone too far in the reach for yield is the lineup of ETF launches over the past year. Of the 214 product ETF launches since the beginning of 2012, nearly a quarter (over 50) are in income-focused ETFs.
To be fair, there’s a wide range of products that fall under that umbrella that I’ve categorized as “income focused,” which includes high-dividend-yield equity ETFs, high-yield fixed-income ETFs, MLP ETFs, private equity ETFs and preferred stock ETFs.
It’s not only the disproportionate number of “income-focused” ETF launches, but also their nature, many of which have become increasingly esoteric, risky or just downright expensive.
Take, for example, ALPS’ U.S. Equity High Volatility Put Write Index Fund (HVPW), which aims to distribute 1.5 percent of its NAV every 60 days. The fund writes 60-day listed put options on the 20 most volatile (demand highest premium) mid- to large-cap securities.
I won’t say it’s like picking up pennies in front of a steamroller, because 1.5 percent every 60 days is a juicy yield; rather, it’s like picking up $100 bills in front of a steamroller. A steamroller can incur some steep medical expenses.
Another example is Van Eck’s Market Vectors BDC Income ETF (BIZD), which tracks an index of publicly traded business development (private equity) companies. Investors are buying shares of an ETF that buys into private equity firms that in turn buy ownership in individual private or thinly traded companies.
The multiple layers of management help explain, although not justify, the fund’s astronomical expense ratio (7.56 percent), which is currently the highest expense ratio of any U.S.-listed ETF.
3) An Unlikely Source of Yield
My final point as to how we’ve gone too far in the search for yield is the suggestion I’m about to make. It’s self-fulfilling but intriguing nonetheless.
Several funds generate high dividend yields without their underlying securities generating any dividends.
How? From securities-lending revenue:Some ETFs hold securities that are highly sought after in the loan market for short-sellers; for example, and thus generate superior revenues from lending those securities.
In some cases, those securities-lending revenues are sufficient to deliver a hefty dividend yield to ETF holders.
It’s hard to say which securities will be the most highly sought after by short-sellers moving forward, but some of the past favorites appear to be ETFs with renewable energy stocks or mining stocks.
I’m not suggesting that most investors jump in front of a metaphorical wrecking ball that could be a tide of short-sellers, but if you have a well-founded conviction in the sector, it could be a double whammy:current income and future growth.
Ultimately, there are several signs that we may have already overstretched our reach for yield. ETF products such as the high-volatility put-write product enforce my conviction as does the rapid growth of the “income-focused” ETF market in general. Be wary of any promises or suggestions of yield and, as always, be sure to fully understand the risks involved.
At the time this article was written, the author held no positions in the securities mentioned. Contact Spencer Bogart at firstname.lastname@example.org.
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