KNG ETF: a good income generator with a yield of 3-4%

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Investment thesis

For years, income investors have struggled to generate anything beyond bare returns without venturing too far into credit quality or maturity spectrum. Sure, you can find something like a 4% yield on junk bonds, but that’s not exactly the best time to pile into low-quality debt before entering a cycle of rising rates. of interest.

Income-equity investors could face an even tougher time. If you ignore the mini bear market of 2018 and the COVID recession of 2020, when yields artificially rose for short periods, the S&P 500 (NYSEARCA: SPY) hasn’t had a 12-month dividend yield of more than 2% since January 2016. Today, it only has a current yield of around 1.3%.

Equity investors like to drift towards the dividend aristocrats for their income needs, but there too, there hasn’t been much opportunity. Long-term dividend producers, as measured by the ProShares S&P 500 Dividend Aristocrats ETF (BATS: NOBL), offer a current yield of only 1.9%. It seems that a higher yielding option from this segment just isn’t in the cards.

Where is it?

There is actually an ETF that invests in dividend aristocrats, but also offers a current yield of almost 4%. The FT Cboe Vest S&P 500 Dividend Aristocrats Target Income ETF (BATS:KNG) combines the long-term dividend growth potential of stocks with a covered call strategy to accentuate the portfolio’s income potential. There are, of course, some trade-offs when it comes to investing in covered call strategies, but KNG could be the answer to getting a high return from the equity portion of your portfolio without venturing too far on the spectrum of risk.

Fund

KNG tracks the Cboe S&P 500 Dividend Aristocrats Target Income Index Monthly Series, which according to websiteis:

“a rule-based buy-write index designed with the primary purpose of generating a level of annualized income from stock dividends and option premiums that is approximately 3% higher than the annual dividend yield of the S&P 500 Index and a secondary objective of generating capital appreciation based on the price returns of the equity securities contained in the index. »

This is an important part of the strategy to understand – it aims to generate a 300 basis point yield premium to the S&P 500, not the Dividend Aristocrats Index. The two indices currently have a return difference of around 60 basis points, so the target return would currently be around 4.3%, not 4.9%, based on the current performance of the S&P 500 .

The index is made up of two parts:

  • An equally weighted portfolio of stocks contained in the S&P 500 Dividend Aristocrats Index (the “Aristocrat Stocks”) that have options that trade on a national stock exchange.
  • A continuous series of short (written) call options on each of the Aristocrat shares (the “Covered Calls”).

The S&P 500 Aristocrats’ equally weighted portfolio is the exact same strategy used in NOBL, so the fundamental KNG portfolio should be a virtual match. The definition of “dividend aristocrat” is a stock whose company has increased its dividend payment every year for at least 25 consecutive years.

Here’s the covered call strategy, again, according to the fund’s website.

Covered calls are written (sold) by the index on the third Friday of each month with an expiry usually on the third Friday of the following month and a strike price as close as possible to the closing price of the underlying Aristocrat stock at this moment. the covered call is written. The index uses a “partially covered call strategy”, which means that covered calls will be written on a notional value not exceeding 20% ​​of the value of each underlying Aristocrat stock, so that the position short in each call option is “covered”. by a portion of the corresponding Aristocrat stock held by the index.

KNG’s strategy is rather interesting. Many covered call ETFs (or CEFs for that matter) like to use either a full overlay strategy or one that sells options on at least half of the portfolio. The higher coverage often produces the big returns that grab the headlines (the Global X S&P 500 Covered Call ETF (NYSEARCA: XYLD) uses a full options overlay and has a 12-month yield of 10%), but this comes at the expense of the potential for stock price appreciation. KNG uses a minor portfolio overlay in an effort to achieve a slightly higher return. Depending on your goal, this can be an advantageous way to approach income-oriented investing, as it allows for above-average returns without giving up great upside potential.

Disadvantages of covered call strategies

Covered call strategies can be beneficial for income seekers, but only if they are willing to give up some potential for capital appreciation. Volatility is the enemy of covered calls, as is the rising stock market. Both environments increase the likelihood that the stock price will exceed the call option strike price and that the shares held will be repurchased.

Therefore, this is a fairly narrow set of circumstances in which covered call strategies can produce gains AND outperform their underlying benchmark. In particular, you need a low-volatility market where stock prices move sideways or decline slightly. If the stock price rises too much, the options will be called and you will sacrifice your earnings. If stock prices fall, you will likely outperform by the amount of the performance bonus, but you will still be liable for market losses.

KNG vs. NOBL vs. SPY Performance

Since the launch of KNG in early 2018, market conditions have not necessarily been favorable. We had a fairly steady rise in stocks from 2019 through the COVID bear market, followed by a period of high volatility, and then another steady rise in stock prices. Neither environment was conducive to the low volatility sideways markets in which covered call strategies perform best.

Still, KNG’s performance against NOBL wasn’t that bad.

KNG vs NOBL ETF return
Data by YCharts

Dividend payers, in general, underperformed the broader market, so it’s no surprise to see the S&P 500 do better. KNG has lagged NOBL by the equivalent of about 1% per year since its inception. The relatively low option overlay has allowed KNG to participate in most market upsides, but still offers a yield that has hovered between 3.5% and 4% for most of the past two years.

It should be noted here that it will be important to keep an eye on the overlay percentage of KNG’s options. In the prospectus it is stated that the fund may write options on a maximum of 20% of the underlying stock position. At the end of 2021, this percentage was only 5%.

KNG ETF Current Options Overlay

KNG Option Overlay (Cboe Vest)

If KNG sells options on only a small percentage of the portfolio, it does not become so different from NOBL. NOBL charges an expense ratio of 0.35%, but KNG’s is 0.75%. That’s a significant cost difference for what might end up being a small yield benefit.

Of course, the option overlay percentage doesn’t necessarily tell the whole story. If KNG can achieve that 300 basis point yield premium without having to write many options contracts, that’s still acceptable. History has shown, however, that it has generally been insufficient.

KNG ETF Distribution Yield
Data by YCharts

The difference between the trailing 12-month returns on KNG and SPY is typically between 200 and 250 basis points, not 300, which is the fund’s target.

I don’t know if I would go so far as to call this a red flag for KNG, but it’s really disheartening to know that they’re announcing a 300 basis point yield premium target to that of the S&P 500, but steadily falling below this target. A consistent return in the 3-4% range on a portfolio of Dividend Aristocrats will certainly look attractive, but I’d rather see that return north of 4% right now.

Conclusion

Overall I like KNG and what it offers. I just wish the yield was a bit higher.

The idea of ​​only using a small covered call strategy to increase an ETF’s yield without giving up a lot of upside potential is appealing, especially in a world where many issuers are aiming for the moon in terms of returns. . KNG hasn’t really participated in a market that was designed for covered call strategies to outperform and I would like to see how the fund manages to perform in this situation.

If you’re willing to accept a current 3-4% return instead of the 4%+ return that would be expected if the fund hits its target, I think KNG works well as an income producer.

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