Getting a Handle on Distribution Yield

Here’s the description and objective for an ETF that’s pulling in the assets these days:

The Strategy Shares Nasdaq 7HANDL™ Index ETF (HNDL) is a first-of-its-kind target distribution ETF designed to seek investment results that correlate generally, before fees and expenses, to the price and yield performance of the Nasdaq 7HANDL™ Index.

The index is split into two components, with a 50% allocation to fixed income and equity ETFs (the “Core Portfolio”) and a 50% allocation to a “Dorsey Wright Explore Portfolio,” a tactical allocation with U.S. fixed-income, U.S. blend, U.S. equity and U.S. alternative assets, or categories that have historically provided high levels of income.

The Nasdaq 7HANDL ETF has adopted a policy to pay monthly distributions on Fund shares at a target rate that represents an annualized payout of approximately 7.0% on the Fund’s per-share net asset value on the date of a distribution’s declaration.  All or a portion of a distribution may consist of a return of capital from the original investment and the distribution rate may be modified at any time.

As they say, there’s a lot going on there.

Let’s start with the target audience.  A seven percent yield sounds good to most anyone these days, but HNDL appears to be specifically designed to attract individuals, and the list of firms reporting holdings in it (via 13F filings) is almost exclusively brokers and registered investment advisors, as you would expect.

How would you go about analyzing the fund?

The current allocation is 43% bonds, 26% stocks, 21% defensive stocks/alternatives, and 10% cash.  On the surface, given the capital markets assumptions of most firms, you couldn’t expect to get to the target yield over the next few years, even assuming heroic allocation moves.  But the since-inception annualized return is 7.09%, which is certainly convenient.

Here’s a look at relative performance and assets over that time:

The fund reports performance against the Aggregate, and Morningstar puts it in the Conservative Target Allocation category.  Given the portfolio makeup and the obvious equity beta displayed via the chart, the Aggregate is an inappropriate benchmark — and the fund maybe should be in a different Morningstar category too.

The third line in the top panel shows performance against the underlying index for the ETF, illustrating the persistent weight of fees and expenses.

As you can see in the bottom panel, assets have exploded this year.  Perhaps buyers are comparing the fund to those indexes, even if they don’t really fit.  But there’s another factor:  that distribution yield.

A flyer on the website is titled “Return of Capital (ROC) Distributions Explained.”  It lays out the case for ROCs and when they can turn out to be beneficial, including an “example of potential tax benefits.”  A contrary example is not provided.

A small section says, “Look at the change in a fund’s NAV to understand the economic impact of the ROC distribution”:

Did the fund’s NAV rise over the long-term and is it likely to do so in the future?

» Yes:  earned distribution that is constructive and positive for the investor.

» No:  the fund did not earn its distribution, which can be destructive and ultimately dilutive for the investor.

Which brings us back to the likelihood of reaching that seven percent distribution, the monthly equivalent of which is paid out like clockwork — and to whether buyers understand the possibilities regarding the return of capital under various scenarios.

SEC rules require funds to provide estimates of the return-of-capital portion “whenever the distribution comes from a source other than the net investment income earned by the fund.”  Yet, because the interim numbers aren’t official, many data platforms list the whole amount as income and/or report the rate for the year as “yield.”

The term “distribution yield” is technically correct, but confusing to many people who don’t understand the nuance involved, yet the ETF provider uses that heavily in its marketing efforts (as in its press release when the fund crossed the billion-dollar mark).

Would you be a buyer or a seller of HNDL?  What do you think the assets under management will be a year from now, or five years from now?