Hello again everyone! It’s been a few weeks since my last post and I hope you’re all doing well. The market has been rolling right along, dismissing virtually any negativity as it climbs higher. As I think about that I’m reminded of Isaiah 40:4-5, “Every valley shall be lifted up, and every mountain and hill be made low; the uneven ground shall become level, and the rough places a plain. And the glory of the Lord shall be revealed, and all flesh shall see it together, for the mouth of the Lord has spoken”. Meaning to me, no matter what is happening around us, if we focus on Jesus, we can keep going. He isn’t worried about any storm or valley, to Him they don’t matter. I hope today we can all keep our eyes set on Jesus and watch the mountains and valley’s just disappear.
With that, I wanted to follow up on my last post, “If I we’re starting with $1,000; I might do this”. In that post, I talked through a hypothetical strategy to take advantage of the highest yielding ETF’s currently available. However, one very important component I failed to discuss thoroughly is NAV erosion. It really is the silent killer to these high yield ETF’s.
So, in today’s post, I wanted to discuss briefly what it is and why it may be the exact reason to avoid the high yield space altogether.
Post Agenda
What is NAV Erosion?
Very simply, NAV erosion, is the principle value loss of an investment. For a more detailed review of NAV erosion here is an article from IncomeShares.com, “NAV Erosion Explained: Why it Matter in Options ETP’s”. To state it another way, NAV erosion takes away any gain that may exist from the dividend being paid.
In a way, with an eroding net asset value(NAV), we end up a part of a useless accounting equation. Where in, we receive a dividend in our left hand but lose the same amount from our right hand. For clarity, imagine we invest $1,000 into a high yield fund. Shortly after, we receive our first large dividend of $50. We’re pumped and the dopamine hit of a cash payment makes us want more. However, with a closer look we may learn that our $1,000 investment is now worth $950. We still only have $1,000 but we’re tricked into seeing it as a win.
To throw salt on that wound, we may also have a tax bill from the distributions come tax season. Essentially meaning, we paid the fund fees and taxes just to keep our own money. Those sneaky investment companies!
In all, high yield isn’t worth the trouble if the NAV erodes over time. If the NAV declines due to market bearishness but climbs during market bullishness, there is less to fret over. If the NAV just declines, “Houston, we have a problem”!
My Experience with High Income ETF’s
First, let me say I have a small percentage of my portfolio inside these high yield funds. Though, even that small percentage equates to several thousand dollars. And I have witnessed a significant NAV decline in the highest yield funds I own. I’m looking at you YieldMax! As a sidenote, If you want to see how I’m doing across my various portfolio’s, here is my Investment Locker.
Having said that, these funds have done what I wanted them to. They’ve boosted the overall yield of the portfolio. I didn’t go heavy into any one high yield fund, rather I tried to pair them with more sustainable investments. It was an attempt to create a symbiotic relationship of sorts, where the high yield declines were offset by the growth elsewhere. By in large, it’s worked as intended but that’s also a result of the bull market. If the market turns over, who knows where I’ll be.
As an options trader, I had at least an understanding of these funds from the beginning. They just simplified what I was already doing and charged a fee for the service. What may not be clear though to someone unfamiliar with options is, there is always a trade off with options. Want income? You’ll have to give up appreciation. Want growth? You may have more risk if the market swings big.
All of that to say, with options ETF’s, the trade offs lend to the NAV erosion problem. A problem that isn’t apparent at the outset and is marketed to us as investors in a way that we don’t see the issue until it may be too late. For now, my 2 high income portfolios are performing adequately but neither of them is beating the S&P 500 in total return. And they’re not even close.
Are High Income ETF’s Worth the Headache?
Well, that really comes down to the individual investor. For me they are but only because I use the income elsewhere. In my Income portfolio, I’ve tried to build it in a way that removing the dividends wouldn’t cripple the portfolio. By having several growth investments there as well my hope is that when I begin deducting all of the dividends the portfolio will continue growing. Albeit at a lower pace. My goal with that portfolio isn’t to grow the principle but to grow the yield. Yield I will then use as a vacation fund.
My second high income portfolio is my Insurance Income portfolio. It’s my highest yield portfolio and notably, also my worst performing portfolio. I use the yield here to buy puts and really nothing more. I know the day is coming when the market enters a year(s) long bear market or even just the random 5-10% decline period. In those instances, I want at least some protection. For now, it’s just wasted money but if the bear ever comes I’ll be glad to have the insurance.
So, are high income ETF’s worth it? Maybe, but I think only if there is a use case for the income. For me, the hope is I can generate yield to pay for the aforementioned items. Yield that exceeds just having paid for them out of pocket.
As an example, suppose I wanted to go to Greece (which I do) and let’s assume it costs $1,000. Its really more but for the sake of discussion. If I take $1,000 from savings to pay for the trip, that $1,000 is gone forever. My thoughts using high income funds is, I’ll take $5,000 from savings, invest it into these funds, and have them yield $1,000 each year. In this way, I get to pay for my trip while also keeping the investment.
Final thoughts
NAV erosion is winning. Don’t be caught off guard expecting a 50-100% yield investment to ever return that in net profit. At most, I would expect a net return of 30% and even that’s a stretch. Clever marketing and the high yield percentage distract from the reality of these funds. They use options to generate income but with options there is always a trade off. That trade off generally is upside appreciation.
If the NAV erodes faster than the dividend pays, it’s a losing investment. Should you want an investment that can grow, look elsewhere. That said, if you’re looking for income, or the possibility of income in excess of the capital you currently have, these funds may fit the bill.
Still, the argument in favor of just investing for growth and selling shares when the capital is needed can’t be ignored. In this way we may actually generate alpha and not just be apart of the fancy accounting function.
Until the next post.
God bless,
Jeff
