This ETF Promise of 7% May Be Too Good to Be True...
In a world of historically low interest rates, everything looks smaller.
Back in the good old days, before interest rates collapsed, it was not uncommon for investors to expect total returns on their portfolios to average in the double digits. When interest rates collapse to the low single digits, it becomes almost impossible to expect a balanced portfolio to generate more than mid-single-digit returns.
For an investor carrying a mix of 60% stocks, 40% bonds, it would take a sustained return of 16% in stocks to average 10%/year in total return. This is a much higher return than one would expect the stock market to be able to maintain.
One way to lower the stock return hurdle is to increase the mix held in stocks. This is tempting but must be carefully considered in light of the higher risks assumed.
The other tactic is to look for alternative sources of yield for the fixed-income portion of a portfolio. Higher yields are certainly available, but those yields are only available in securities with higher financial risk.
The bottom line is: there’s no simple fix to low interest rates and a risk equivalent reduction in expected returns. Either you accept what the market provides and hope for better yields in the future, or you assume greater risk in your portfolio.
Of course, Wall Street seizes upon these moments to create products that seemingly solve the problem. One such vehicle is the Strategy Shares Nasdaq 7HANDL Index ETF (HNDL).
This ETF began trading in January of 2018 and promises investors a return of 7%, no matter what transpires with its underlying investments.
The investments used by the fund are defined in the prospectus as being comprised of the constituents of the Nasdaq 7HANDL Index, which consists of the lowest cost ETFs.
50% will be invested in fixed income and equity ETFs with the remaining 50% invested in 12 different asset categories, including dividend stocks, high yield bonds, and REITs to name a few.
The fund currently holds 19 ETFs in its portfolio; some are well known ETFs like the Invesco QQQ ETF (QQQ), while other holdings like the iShares Preferred and Income Securities ETF (PFF) are more obscure.
The managers of the Strategy Shares Nasdaq 7HANDL Index ETF are betting that they can distribute 7% per annum rain or shine. In years they fail to generate the 7% total return, they will distribute principle from the fund to make up the difference.
Also noted from the prospectus is the Strategy Shares Nasdaq 7 fund allows its managers to use up to 23% leverage in the portfolio. Leverage is used to turbo charge returns and boost income. Leverage can also backfire spectacularly if the market goes the wrong way…
So how has this relatively new fund fared?
Since inception, the net asset value of the fund is essentially flat, trading just below the initial offering price of $25 per share. That means the average total return for the fund has been just what it promised, a 7% annual yield.
The data available to the public makes it hard to dissect exactly how that return has been generated. More important to know is: has the fund had to dip into principal to make up for a lower than 7% total return?
It appears they haven’t, but that’s not a surprise.
Since inception of the fund, stock prices rose. In addition, interest rates continued to fall so bond prices have risen. This made hitting the promised 7% return easier.
To say it will continue to be easy requires faith in the stock market in the years to come.
What do we make of the Strategy Shares Nasdaq 7HANDL Index ETF?
The biggest concern I have is that there’s an awful lot of financial engineering being used by the fund. The combination of leverage and long-duration fixed-income ETFs can conspire to turn returns quickly. Although impossible to fully analyze, I would expect the fund to be vulnerable to rising interest rates.
Meeting their return threshold in the past only shows that under specific market conditions, the fund is able to deliver. Can we expect things to continue as they have? Of course not. Markets are always changing.
Like with any investment decision, whether it be the mix of stocks and bonds you hold or the individual securities you buy or sell, success is always the result of understanding what you own and why. You should always weigh both the potential return against the risks you are assuming.
Guaranteed or promised annual returns always concern us because no single strategy works in all markets. As a further note of caution, we would almost always tell you to avoid complex investments as you will never truly understand what it is you hold and you should always understand your risks.
I fear, when seeing a fund like this, the notion that a stated promise of 7% is somehow equated to guaranteed income. It is not. It’s a strategy that certainly works in some markets, but unlikely all.
Instead, a customized portfolio that fits your needs in light of current circumstances is our preference. When interest rates are low, it shouldn’t drive you to taking greater risk. You should assess your portfolio in light of the changed conditions and take reasoned actions.
If you are concerned about income and would like to learn about the Nicollet Investment Management approach, please give me a call.