Isn't ROC Supposed To Be A Bad Thing?


Dorsey Wright in conjunction with NASDAQ launched what I think is a first of its kind fund called the Strategy Shares NASDAQ 7HANDL Index ETF (HNDL). It is billed as a target distribution fund that will target a 7% annual payout (it is a monthly pay). The website for the fund is outstanding as far as laying out the strategy; there is a core/explore element to it, a tactical overlay and it includes alternatives, or at least what they think of as being alternatives.

The core holdings include Schwab US Aggregate Bond SCHZ at 10.41% of the fund, SPDR Portfolio Aggregate Bond (SPAB) 10.39%, iShares Core Aggregate Bond (AGG) 10.37%. All three funds have yields in the two's and they all track the same index. One reason why there might be three funds tracking the same index is that there are limits to how much exposure a fund of funds can have to one fund.

HNDL also owns a couple of S&P 500 funds in small weightings, a couple of covered call ETFs, dividend funds, utilities, MLPs and several other bond ETFs that might be familiar to you. I am assuming that SCHZ, SPAB and AGG are part of the core as they intuitively seem like core holdings and have such large weightings in the funds but I am not sure it matters whether they are core or not, they are in there, like most ETFs there is daily transparency for anyone to see the holdings.

Part of the equation is that the fund uses leverage to try to enhance the yield. It can lever up by 23%. The leverage is kind of in the realm of a closed end fund but HNDL will use swaps derived from the underlying HNDL Index to create the leverage. The way I read the fact sheet, the fund will maintain the leverage which if correct would likely magnify any drawdowns the strategy might encounter.

The other point that is made plainly and repeatedly is that some or all of the monthly payout will be a return of capital. The downside of ROC is it erodes the principal which depending on what happens in the market could cause the fund to dwindle. The upside is that any portion of the payout that is an ROC is not taxable. ROCs are more of a closed fund thing like when CEF owns fixed income, they have a very high "yield" and return capital (a lot or a little) to maintain the payout. Equity CEFs frequently also have ROCs.

An ROC is like withdrawing principal. If you read some of the dividend bloggers at Seeking Alpha they write that they will only spend dividend payments, never principal. The conversation is often framed at dividend investing versus total return investing and they seem to not believe in total return and I am not sure why. As an extreme example if you had every nickel in Facebook (FB) last year, your portfolio was up 50% and you took 5% to live on, that would seem to get the job done. More realistically if a diversified equity portfolio was up 17% last year plus a yield of 2.4%, so a small lag, again it would have gotten the job done. Starting January 1, 2017 with $500,000, the least favorable sequence would have been to take the entire 5% right away, dropping the account to $475,000, getting it to $567,150 at year end.

Using the above example is probably how you have to view the fund but the big difference is HNDL is more fixed income than equity. It can get some price appreciation but it is 70% fixed income so I wouldn't expect a lot of price appreciation very often. Interestingly, had it launched a year ago its price appreciation could have been enough to cover almost all of the 7% payout. A 30% equity allocation that went up an index-matching 20% would have contributed 6% growth plus the yield from the fixed income and the fund would have not dwindled from an ROC. That example is simplified but illustrates a scenario where growth could cover decent chunk of the 7% "payout."

A lot of closed end funds have the tendency to go from the upper left to the lower right, as Dennis Gartman might say, so I will be curious to see whether HNDL can avoid that chart pattern, it is not clear to me that it can. 7% is a big bogey.