When I started my ETF Insights platform, I issued a newsletter covering the main benefits and pitfalls of high-yielding ETFs.
In this month’s newsletter, I want to focus on a different type of higher-yielding ETF, mainly single-stock ETFs, and the aggressive marketing campaigns and fund launches being utilized by many fund managers out there.
As much as I like to talk about strong funds and funds that fit well into a long-term buy-and-hold ETF portfolio, I feel it’s just as important to identify and discuss funds that, in the end, likely only make the fund managers prosperous, not investors.
My approach this month will be to discuss the funds and the misconceptions displayed by the investing community, particularly influencers, as to the benefits these funds offer.
Let’s dive right into it.
Single-stock income ETFs are exploding in popularity
I’m sure throughout your investing career, you’ve heard the phrase:
“If company ABCXYZ starts paying a dividend, I’ll buy it…”
Fund managers heard this too, and they can make this happen with the ways they can structure exchange-traded funds. Their underlying motivation isn’t to give yield to those who seek it. The motivation is to capture fees from a passive income trend that is exploding in popularity.
However, many funds have gone far beyond offering simple yields on these stocks. Many advertise 20%, 30%, or even greater yields.
There is a saying in the investing world:
“There is no free lunch in finance.”
The meaning of the phrase is that to achieve something, you have to be giving up something else. There is always some kind of cost. In this instance, achieving an abnormally large yield from a stock will likely come at the cost of something else. Whether the cost is taking on additional risk, giving up potential pricing upside, or paying higher fees.
Unfortunately, for many of these single-stock ETFs, the answer is pretty much all three.
Why these funds are gaining in popularity, and why fund managers are getting them out as fast as possible
I’ve attached a chart below from Google Trends for the keyword “passive income.”
As you can see, especially during the pandemic, popularity of the term skyrocketed. The higher the blue line, the higher the interest.
I cannot provide a certain reason as to why this is happening, but I can make a reasonable assumption that it is due to many people being shaken by the pandemic, whether it be losing their job or skyrocketing costs, and they have now turned to many influencers speaking about how they need to have multiple sources of income.
As the markets continue to reach all-time highs, many of the best-performing options out there are not stocks that pay a dividend. So, it was a relatively safe assumption that if managers could somehow turn a high-flying growth stock like Nvidia into a passive income machine, money would flow into these funds.
And this has definitely turned out to be the case. As a result, we’re seeing an enormous amount of single-stock ETFs being brought to market in the United States. They are even coming to Canada, with Harvest releasing single-stock income ETFs just a few weeks ago on MicroStrategy, Coinbase, Palantir, Tesla, and Meta.
I don’t think this will be the last batch of funds released, either. As long as money continues to flow into them, fund managers will continue to produce them.
The allure of these funds is income, but some of the supposed “benefits” have zero historical proof
I’d like to preface this by stating that it is not the fund managers providing the supposed benefits of these stocks but more so financial influencers. Fund managers must be transparent on the risks and benefits of particular funds, and certainly can’t sway investors with misleading information.
Influencers, on the other hand, are doing so in droves. I cannot say what their intentions truly are. It may be a lack of knowledge, or it may be something else.
There is a mentality among the passive income community that a bird in hand is worth two in the bush. Why expose yourself to the volatility of a company like Nvidia, one that pays a minuscule dividend, when you can get similar exposure and earn a 58% distribution (I’m not kidding on this; I’ve attached the distribution rate directly from Yieldmax in an image below).
In a situation where the market crashes, investors who own NVDA will be exposed to the entire drawdown of the stock but will receive no income. Investors who own NVDY, on the other hand, will still receive distributions.
Effectively, they are trying to mitigate sequence-of-returns risk with passive income. The only difficulty here is that no historical studies suggest this type of strategy works.
What is sequence-of-returns risk?
In a nutshell, sequence-of-returns risk is the risk that you will be forced to draw down on your portfolio during market crashes, which can lead to faster depletion of your portfolio overall.
If you have ever heard an investor speak about how if the market crashes tomorrow, they’ll still have their income, they are effectively stating that the income will provide a buffer against sequence-of-returns risk.
However, the difficulty we run into here is the fact that there is no historical studies or evidence that has shown that dividends provide any sort of mitigation when it comes to sequence-of-returns risk.
And keep in mind, I’m speaking on dividends in this situation. When we factor in these single-stock ETFs, which primarily generate their income through derivatives (options contracts, for example), it creates even more uncertainty in the future.
After all, a dividend is a reliable source of cash flow from a corporation with underlying earnings and free cash flow, and even this form of income has not been proven to provide any sort of reasonable buffer.
Derivative focused ETFs with yields north of 20%-40%? That is an entirely different story
While a dividend is consistent, for the most part, premiums collected from options contracts are anything but.
Case in point? Let’s look to the Yieldmax Tesla ETF, trading under the ticker TSLY. Its distribution has been on a consistent path downward, falling by more than 64% since its inception.
Where it gets even worse is on the total return front. Because of the single-stock ETF’s strategy of selling covered calls, this effectively caps the potential upside the fund can realize. As a result, Tesla stock has provided nearly triple the returns of TSLY since its inception, and this is with reinvesting all distributions received from TSLY.
There is no “buffer” with these ETFs in the event of a market drawdown
The theory is simple from a lot of passive income investors and promoters. If the market tanks tomorrow, you will have a downside buffer because of the premiums generated from the sale of the options contracts. I’ve attached an image below of a popular passive income influencer stating this:
However, when we go back to the fund pages on a lot of these single-stock income focused ETFs, the fund managers state the exact opposite.
“The Fund’s strategy is subject to all potential losses if shares decrease in value, which may not be offset by income received by the Fund.”
And when we look to the drawdowns of NVDA versus NVDY in the chart below, we can see they are exactly the same. There has been no protection to the downside.
And despite numerous passive income influencers stating the contrary (that the funds provide a buffer in the event of a drawdown), it is literally stated in the fund’s prospectus that the fund probably provides zero buffer:
“The Fund expects to participate in all the Underlying Security price return losses over the duration of the options contracts (e.g., if the Underlying Security decreases in value by 5%, the Fund should be expected to decrease in value by approximately 5%, before Fund fees and expenses)…”
Why? Because covered calls are structured in a way that exposes investors to 100% of the downside risk but not all of the upside potential. What you get in return for this trade-off is a premium in the form of cash for selling the options contract to another investor.
If the premiums do not offset the decline in stock price, which is highly unlikely in the case of all these high-growth, high-valuation names if they fall in price, you will face the brunt of the drawdown.
Identical risk for lower upside
Now that we’ve tackled the illusion that these funds provide some sort of downside buffer in the event of a market crash, we can tackle the next issue, which is the fact that you are taking on a similar risk level for less upside.
If we have two investments that have identical risk or near identical risk, we should always choose the one that has larger upside potential.
I will put this into a straightforward example that should make this obvious.
Let’s say I offer you the choice of two investments:
Investment A: $100 invested could end up with a $50 loss or a $100 gain.
Investment B: $100 invested could end up with a $50 loss or a $50 gain.
If we accept the fact that the losses are similar, it makes little sense to take the investment that yields lower potential returns.
Now that I have reviewed the identical drawdowns in the selloff of NVDA and NVDY, I want to highlight the total returns of these funds since their inception:
As we can see, investors holding NVDA have realized nearly double the returns as NVDY, while taking on similar levels of risk.
Yes, some have received “income” from NVDY (I’ll go over why I have that in quotations later), but they have also had to reinvest that income in order to generate those returns.
If a person is in retirement and they have had to utilize those cash flows from NVDY, their underlying capital has shrunk. Below is a return chart if they didn’t reinvest distributions and spent them instead:
I realize there is some unfairness here to a degree. If one was selling NVDA shares to supplement income in retirement, their returns would not be 320%.
But it is safe to say they’d still be substantially higher than the -6% from NVDY.
There are some cases where downside has been protected to a degree, but is it worth it?
When we look to a stock like MSTR and its income variant MSTY, we can see some sort of buffer during its recent drawdown.
However, I would consider something like MSTR a stock with extensive risk and gut-wrenching volatility. I would want to reap 100% of the benefits from owning the stock, considering the risk I have taken on to own it.
And we still get a situation where the income-focused ETF has underperformed the underlying asset by a substantial margin.
Is a 10% drawdown buffer, one that is not guaranteed to occur again in the event of a drawdown, worth the 130%~ lower total returns over the span of 10 months?
That is completely up to the individual. But in my honest opinion, it’s not worth it.
The impact on distributions from the fund
There is an age-old debate (which, in reality, shouldn’t be a debate) as to what happens to a particular stock or fund when it pays a distribution.
In reality, the fund or stock decreases in value when a distribution or dividend is paid. It is a realization of equity. Money that is removed from the fund or stock you own and transferred to you, the owner of the units or shares.
Regardless of whether or not we are at all-time highs or 52-week lows in terms of the market, these income funds pay the distribution out of the net asset value of the fund and back to the investor, which lowers the value of the ETF unit price.
If we consider the fact that an ETF’s unit price is simply its net asset value divided by the amount of units outstanding, we can begin to see why our unit price goes down.
A fund with $1M in net asset value and a million units outstanding is worth $1 per unit. Pay out a 10-cent distribution, and you now have $900,000 in net asset value with 1 million units outstanding, or around $0.90 per unit.
The “income” generated from these ETFs is nothing over and above what would be received outside of selling units of the fund.
This is precisely why we see in the chart below that the net asset value of NVDY has effectively remained flat since its mid-2023 inception despite NVDA increasing in price by 318%:
The fund has effectively paid back all of its increases in net asset value back to investors, which, don’t get me wrong, is what the fund is designed to do. The difficulty here is that it has returned around half of what NVDA has.
This is a combination of the fund being dependent on covered call income from selling options plus the fact that selling those covered calls has capped its upside in terms of appreciation of its net asset value.
In the end, someone looking to generate income in retirement would have been substantially better off periodically selling shares of NVDA.
Overall, if I am looking to reap the benefits of the market over the long-term, I’m not a fan of these funds
Ultimately, my negative viewpoints from these funds comes not from personal bias or opinion but from historical studies and data that suggest the main benefits of these funds are largely over-stated, and investors are taking on equal levels of risk to generate lower levels of returns, and paying 1%+ management fees to do so.
The high yields offered by these funds, aggressive marketing tactics from fund managers, and misinformation spread by financial influencers (whether this is due to a lack of knowledge or some other underlying motive, I have no idea) make them an easy trap for investors to fall into while attempting to build up a passive income stream.
When we look to historical studies on market returns plus studies that have highlighted the proper ways to mitigate sequence-of-returns risk, we begin to see the flaws in these funds.
Humans fear loss much more than they desire gain. For this reason, many will opt for the “bird in hand is worth two in the bush” perspective when it comes to being paid realized distributions. However, in the short duration these funds have existed, they have exhibited similar volatility with substantially lower returns.
And we haven’t even hit a bear market yet.
