The competition among Exchange-Traded Fund (ETF) issuers to maximize income from stock portfolios intensified on Tuesday with the introduction of a new fund by Pacer. The firm launched the Pacer Metaurus Nasdaq-100 Dividend Multiplier 600 ETF (QSIX), complementing its existing US Large Cap Dividend Multiplier 400 ETF (QDPL), which has accumulated over $500 million in assets since its inception in 2021. The primary objective of these funds is to achieve distributions that are six times the dividend payouts of the Nasdaq-100 Index and four times those of the S&P 500, respectively.
In recent years, income strategies have seen significant growth among ETF issuers, with covered call funds emerging as a favored niche. According to FactSet, Global X covered call ETFs on the S&P 500 (XYLD) and Nasdaq-100 (QYLD) now possess more than $10 billion in combined assets. Additionally, JPMorgan’s Premium Income ETFs (JEPI and JEPQ), which utilize a variation of the covered call strategy, have collectively amassed over $50 billion in assets.
One possible drawback of covered call funds is the imposed limitation on the potential portfolio upside within the portion covered by the call option. The concept behind Pacer’s funds is to capture more upside during market rallies. According to Sean O’Hara, president of Pacer ETF Distributors, QDPL currently allocates approximately 89% of its exposure to S&P 500 stocks, utilizing the remaining portion to trade dividend futures for enhanced income. Importantly, there is no hard cap on the upside for the equity portion.
O’Hara explained that the aim for QDPL is to achieve a total return akin to the S&P 500, while generating cash flow equivalent to four times the S&P 500’s dividend yield. QSIX operates similarly but targets Nasdaq-100 stocks.
The Pacer funds replicate the holdings of the underlying equity index and simultaneously take long positions on dividend futures contracts spanning the next three years. The equity exposure and dividend futures exposure ratio are adjusted during the annual rebalancing to meet the target multiplier for distributions.
By maintaining all index stocks in the portfolio, the funds seek to mitigate sector and style risks associated with funds that only invest in dividend-paying stocks. According to O’Hara, focusing solely on dividend-paying stocks typically leads to a significant allocation in sectors like financials, utilities, and real estate, which generally exhibit limited earnings growth.
Over the past three years, QDPL has outperformed several popular dividend-focused funds, including the ProShares S&P 500 Dividend Aristocrats ETF (NOBL) and Schwab US Dividend Equity ETF (SCHD), on a total return basis. However, it has underperformed the Vanguard Dividend Appreciation ETF (VIG).
Dividend futures are based on indexes that track total annual dividends paid by a group of stocks, translated into “points” by S&P Dow Jones Indices. These futures contracts essentially represent a bet on the total points expected by a specific date, according to CME Group.
The income generated by income ETFs varies and can impact investors’ annual tax bills differently. The income for Pacer funds, for instance, originates from three distinct sources, influencing after-tax returns. For 2023, Pacer estimated QDPL’s income composition as 23% from S&P 500 dividends on underlying holdings, 8% from capital gains on futures contracts, and 69% from return of capital. QDPL’s distribution yield is currently 5.79%, significantly higher than the S&P 500’s approximate yield of 1.3%, as reported by YCharts.com. However, its 30-day SEC yield, which excludes the return of capital from futures contracts, stands at 1.01%. In contrast, JEPI derives a substantial portion of its income from fees earned by writing call options, boasting a 30-day SEC yield above 7%.
One potential advantage is that the return of capital portion from Pacer funds may not be counted as taxable income. However, this return of principal could lead to a reduction in assets under management, potentially impacting long-term performance. The capital gains from dividend futures result from contracts often being priced at a discount to projected payouts, compensating investors for risk.
Dividend futures could also see higher gains if more companies in the index begin paying dividends. O’Hara noted that many prominent names in the Nasdaq currently do not issue dividends, suggesting potential upside if companies like Amazon or Tesla initiate payouts. For context, Meta Platforms began issuing dividends in March, Apple in 2012, and Microsoft in 2003.
However, it is important to recognize that dividend futures contracts could decrease in value during periods of economic stress. For instance, numerous companies, including major banks, suspended their dividends during the Covid-19 pandemic.
