QYLD - KNG: Not The Buy/Write ETF King

2023-07-29 01:24:33 ET

Summary

• KNG employs a buy/write strategy quite successfully, considering the small opportunity cost in relation to market total returns and the decent dividend yield over the years.
• However, it comes second in its efficiency both in the world of buy/write ETFs and pure dividend-income ones.
• Interested investors should understand why this is so as they do their research, and this article will serve them well in that regard.

Thesis

FT Cboe Vest S&P 500 Dividend Aristocrats Target Income ETF (KNG) is a buy/write ETF that focuses on buying dividend aristocrats and writing covered call options on them. While it seems successful in employing this strategy to produce a decent income stream without incurring a large opportunity cost, it seems to not be the best option out there. Far from it, actually.

In this post, I will take a hard look at the performance of this ETF since it was launched and illustrate how it is one of the best income ETFs out there but also how investors may be better off looking elsewhere. Let's get into it.

What does KNG do?

KNG is an ETF that was issued by First Trust Advisors LP on March 26, 2018 and is managed by the same and CBOE Vest Financial. Its current AUM comes at $844.43 million.

The fund's goal is to replicate the performance of Cboe S&P 500 Dividend Aristocrats Target Income Index Monthly Series, before fees and expenses. This is an index that reflects the value of a portfolio that employs a buy/write strategy. It consists of equal-weighted stocks in the S&P 500 Dividend Aristocrats Index and written call options on each of those stocks. The point of this strategy is to amplify the income generated from dividend-paying stocks.

Besides the fact that stocks must be included in the S&P 500 Dividend Aristocrats Index, the criteria that the ETF's index uses to select its securities are the following:

1. Companies need to have been increasing dividend payments each year for a minimum of 25 years in a row.

2. Stocks must have a float-adjusted market capitalization value of at least $3 billion.

3. Stocks need to have an average daily value traded of at least $5 million.

For those of you who are unfamiliar with a buy/write strategy, let me briefly provide some context with a simplified version of what KNG does. The fund buys dividend stocks and then writes (sells) call options contracts on them; these contracts obligate the ETF to sell the stocks it bought to the buyers of the options at a predefined price called the "strike price" for a period of time if the latter party wishes so. The ETF's goal is to receive the proceeds (premium) from writing the contracts and having the options expire worthless. That results in generating income on top of the dividend income the underlying stocks deliver. If the contracts are exercised, the ETF will need to sell the stocks to the contract holders at the strike price, which will be lower than their current market price (at which the ETF will need to buy the stocks afterward to do everything all over again). Such a scenario represents an opportunity loss for the ETF as it's deprived of enjoying the market appreciation between the strike price and the current one. Of course, the premium received can help offset this opportunity loss. Alternatively, it will have to pay the seller the difference between the market and the strike price.

Now, when the fund tracks the index to the letter, it sells the calls on the third Friday of each month with an expiration date on the third Friday of the following month and a strike price as close to the closing price of the underlying stock at the time of writing as possible. That may ensure a relatively high premium but also involves a high risk of having the contracts exercised.

The reason I made it seem optional that the ETF tracks the index to the letter is that the managers intend to invest up to 20% of the AUM in different securities or options than what the index tracks, but always in an attempt to best match the performance of the index.

Additionally, KNG rebalances the stock positions on a quarterly basis and reconstitutes the stock portfolio on an annual basis.

Last, as of July 24, 2023, the index KNG tracks made two interconnected changes that you should be aware of. First, it now targets an annualized level of income from the dividends and premiums that is approximately 8% over the annual dividend yield of the S&P 500 Index, whereas the target previously was 3%. Second, the index removed the notional value cap of 20% in regard to writing options. That meant that the options the fund would write were covered by no less than 5 times the underlying stocks. Now, the only requirement is that each option is sold on a notional value that is less than the total value of the corresponding stock position at the time of writing. In other words, the strategy still involves covered calls but abandons the previously conservative restriction of how well-covered such calls are. Because of these changes, KNG has changed the distribution frequency from quarterly to monthly.

And now that you understand what the fund does, it's time to see how well it does it. Its strategy may be solid in theory but there is always some uncertainty in regard to how competitive the offering here is after some investigation.

Performance

KNG may be an ETF that prioritizes income over total returns but I am always interested to see how much performance one needs to sacrifice to get that. And there's no better way to assess this than a comparison to the total returns the broad market could deliver. So let's see how well the ETF performed against the SPDR S&P 500 ETF Trust ( SPY ).

Since it was launched (more than 5 years ago), KNG managed to yield about 70% in total returns versus the almost 90% total returns of SPY. Compared to other options that are promoted as "high-yield" vehicles, the difference in performance reflects a relatively small opportunity cost, considering the long time frame here.

And, of course, there is also a higher enough dividend yield to be enjoyed in KNG, potentially making the lower total returns worth it to the average income investor.

What about other options though? Is KNG the king of the buy/write ETF business when it comes to total returns? The short answer is no.

From a small pool of ETFs that employ a buy/write strategy using various indices, the Amplify CWP Enhanced Dividend Income ETF ( DIVO ) comes first in delivering the highest total returns over time. But as you can see from the chart above, KNG didn't do much worse than DIVO. In fact, the rest of the alternatives depicted did worse than KNG and DIVO enough to probably give the interested investor pause.

Not surprisingly, however, KNG and DIVO performed much worse when it comes to dividend returns:

And this is where it gets subjective. Some income investors will find attractive the historically higher dividend yields offered by the 3 ETFs above to perceive the total return underperformance as an opportunity cost worth incurring. Personally, I don't. So this is not as important as the fact that DIVO has historically offered a higher dividend yield than KNG while also outperforming it in terms of total returns. This is what really stands out here and makes DIVO seem the superior alternative to KNG.

But before we can be absolutely sure of this verdict, it's worth taking one look at the risk profile of each ETF:

Source: portfoliovisualizer.com (May 2019 - Jun 2023)

Surprisingly, DIVO has managed to outperform all competitors with the least amount of volatility. Even on a risk-adjusted basis, it is the best-performing buy/write ETF available.

That being said, as I suspect that income-seeking investors are mostly interested in high and sustainable income generation, rather than specifically the buy/write strategy, we also have to consider options outside of this niche. Let us then broaden the search to include other dividend-focused ETFs:

It turns out that there are multiple income-oriented ETFs that have done better than KNG in terms of total returns. What immediately caught the eye is the Schwab U.S. Dividend Equity ETF (SCHD), which greatly narrows the gap between the performance of SPY and KNG (this is the same time frame used to compare KNG to SPY above). Of course, it's reasonable to expect a catch here. It's also reasonable to expect it to be related to the dividend yield. But you'd be surprised. Currently, SCHD can be grabbed at a dividend yield that is almost the same as provided by KNG:

What's more, the returns of SCHD are also superior on a risk-adjusted basis as well:

Fees

When it comes to cost, KNG seems relatively expensive to hold. DIVO, which is one of the closest competitors here charges a far more attractive expense ratio:

Within the context of its underperformance to DIVO, KNG isn't very competitive in terms of fees either.

Risks

Here are three risks that are related to investing in KNG:

• Market Risk: KNG buys stocks and is, therefore, subject to market fluctuations caused by economic, political, and regulatory changes, among other factors.
• Index Concentration: Since the ETF tracks an index, there is a risk that it might concentrate on a particular industry or sector if the index does so. As of January 31, 2023, the KNG was concentrated to a large degree in consumer staples and industrials stocks.
• Covered Call Strategy Risk: Because of how close the strike prices that the fund selects are to the market prices of the stocks they buy at the time of selling the options, there's a great chance options holders end up exercising them.

For a full list of the risks involved, take a look at the ETF's prospectus .

Verdict

In conclusion, it turns out that KNG is a decent income ETF but it doesn't make sense for anyone to hold it over DIVO or SCHD. If income generation with the least possible opportunity cost in comparison to market performance is what you are looking for here, then KNG isn't competitive enough.

But you might have a different take on this, so I would encourage you to leave a comment below and let me know your thoughts. Which points find you in agreement and which ones don't? What is your opinion on the alternatives? What do you prefer holding? Let us start a discussion. And as always, thank you for reading.

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