ALTY - MDIV: Inflation Is A Silent Killer

2023-06-02 12:12:31 ET

Summary

• First Trust Multi-Asset Diversified Income Index Fund ETF invests in 5 categories of high-yield securities.
• Historical performance is close to competitors.
• It has suffered large losses in inflation-adjusted value and distributions.
• Bonus: how to avoid capital decay in high-yield funds.

This article series aims at evaluating ETFs (exchange-traded funds) regarding the relative past performance of their strategies and metrics of their current portfolios. Reviews with updated data are posted from time to time.

Strategy and portfolio

First Trust Multi-Asset Diversified Income Index Fund ETF ( MDIV ) started investing operations on 08/13/2012 and tracks the Nasdaq US Multi-Asset Diversified Income Index, a rule-based model mixing different categories of securities. It is a high-yield ETF with a 12-month distribution rate of 6.93%, a net expense ratio of 0.72% and 125 holdings. Distributions are paid monthly.

As described on FirstTrust website , the fund invests in five asset categories: equity securities, REITs, preferred securities, MLPs and high yield corporate bonds. The underlying index allocates 20% of its weight to each category. The high yield corporate bond category is represented by the First Trust Tactical High Yield ETF ( HYLS ).

Equity securities (excluding real estate investment trusts, or REITs) must meet conditions of capitalization and liquidity, and show:

• a dividend each of the last three years
• positive total earnings in the trailing 12 months
• a dividend payout ratio less than or equal to 80%
• One year realized volatility less than the Nasdaq Benchmark Index, one-year realized volatility plus 15%.

Then, 50 stocks passing all rules are selected and weighted by yield.

REITs must meet the same criteria, with a higher threshold for the payout ratio: 150%. The index selects 25 REITs and weights them by yield.

Preferred stocks must pass a similar screen, without the positive earnings conditions and with lower requirements in capitalization and liquidity. Eligible preferreds are ranked based on yield and volatility. The top 25 are included in the index and weighted by yield.

The rules for MLPs are similar to those for preferreds, with specific parameters. They also result in 25 constituents.

Excluding the high yield corporate bond ETF weighting 21.54% of asset value, the top 10 holdings are listed below.

It is noteworthy that three of the four REITs in this table are mortgage REITs, and they are the heaviest holdings. Several holdings in the preferred category may be issued by the same company. The top four issuers are DigitalBridge Group ( DBRG ) with an aggregate weight of 2.57%, AGNC Investment Corp. ( AGNC ) with 2.48%, Citigroup Inc. ( C ) with 1.60% and Morgan Stanley ( MS ) with 1.60%. They come ahead of the largest holding.

Performance

Since inception in 2012, MDIV with dividends reinvested has lagged the S&P 500 ( SPY ) by 9.8 percentage points in annualized return, and a 60/40 portfolio by 5.5 percentage points. Volatility is similar to the stock benchmark, but the maximum drawdown is deeper. The risk-adjusted performance (Sharpe ratio) is inferior by far to both benchmarks.

The next chart compares total returns of MDIV and three other multi-asset high yield ETFs:

• GraniteShares HIPS US High Income ETF ( HIPS ), reviewed here ,
• Global X Alternative Income ETF ( ALTY ), reviewed here ,
• iShares Morningstar Multi-Asset Income ETF ( IYLD ), reviewed here .

These products are competitors, but they are structured in different ways. HIPS has four asset categories: REIT, MLP, CEF and BDC. ALTY has five, but two of them differ from MDIV: it replaces high yield corporate bonds and dividend stocks by emerging market bonds and covered calls. Starting date is 12/18/2017 to match data availability.

MDIV is in the middle of the pack. However, it is the worst performer in the last 12 months:

The annualized return since inception, reinvesting distributions, is below the distribution rate. This is a clue pointing to capital decay. The next chart confirms it: the share price has lost 29% since inception. In the same time, the cumulative inflation has been about 29%, based on CPI. This represents a huge loss in inflation-adjusted value.

Moreover, the annual sum of distributions went down from $1.18 per share in 2013 to $1.00 in 2022. For shareholders, it means an income loss of 15% in 9 years. In the same time, the cumulative inflation has been 27%. This also means a significant decay in inflation-adjusted income for shareholders.

This decay in capital and income is not a management issue: it's just impossible to make a good recipe with bad ingredients. Securities with yields above 6% suffer from capital decay on average (there are rare exceptions). MDIV can be useful for swing trading or tactical allocation, but history shows it may be harmful as a long-term investment. This is true for most high-yield funds, not only this one.

Bonus: how to avoid capital decay in high-yield funds

Capital and income decay is an issue in many closed-end funds, like in high yield ETFs. However, it may be avoided or mitigated by rotational strategies. I designed a 5-factor ranking system in 2016, and monitored its performance during several years. I started publishing the eight best ranked CEFs in Quantitative Risk & Value ((QRV)) after the March 2020 meltdown. The list is updated every week. It isn’t a model portfolio: trading the list every week is too costly in spreads and slippage. Its purpose is helping investors find funds with a good entry point. In the table below, I give the hypothetical example of starting a portfolio on 3/25/2020 with my initial “Best 8 Ranked CEFs” list and updating it every 3 months, ignoring intermediate updates. Return is calculated with holdings in equal weight and reinvesting dividends at the beginning of every 3-month period.

This simulation is not a real portfolio and not a guarantee of future return

Of course, past performance (real or simulated) is not representative of future return. However, I think a time-tested rotational strategy in CEFs has a much better chance to protect both capital and income stream against erosion and inflation than a high-yield ETF.

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