We typically talk about index funds as being safe, mainstay investments in long-term portfolios. But sometimes, index funds can be used a little more aggressively — for instance, as sources of high yield.
Say you want about a pending Federal Reserve interest-rate hike, but when it comes to significant income, the government’s not exactly going to come to the rescue anytime soon. The 10-year Treasury yields just 2.2% — and a meager Fed hike isn’t going to send that shooting through the moon.
You’re not getting any better from the broader stock market, either; the S&P 500 sports a modest dividend yield of just 1.9%.
Granted, both are very relative safe sources of yield, as Treasuries are backed by the “full faith and credit” of the U.S. government (skeptics can snicker here), while the S&P 500’s roster of blue chips, while not bulletproof, are about as safe as the stock market gets.
No, if you’re hunting for high yield, you typically have to live a little dangerously.
The following five exchange-traded index funds certainly provide investors with high yield, as they all throw off at least 7% annually (and some reach into the double digits). But that kind of yield necessarily comes with risk, so we’ll go through each of these funds to show you what to watch out for should you choose to chase these monster yields.
High-Yield Index Funds: iShares Mortgage Real Estate Capped ETF (REM)
Dividend Yield: 12.8%
Expense Ratio: 0.48%, or $48 annually for every $10,000 invested
The iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM) is a specialized play in the real estate investment trust (REIT) world. Whereas traditional REITs typically own and even operate physical properties, mortgage REITs (mREITs) own real estate indirectly via mortgages.
Both, however, have the same requirement to pay at least 90% of their profits to shareholders, which results in pretty thick dividends.
As one would expect, 13% in dividends comes with a little risk.
Because mREITs have to pay back so much of their profits, their business of buying up mortgages is typically funded by debt, making this asset class extremely sensitive to interest rates. Specifically, when they borrow money, they do so at short-term interest rates; however, the mortgages they buy are lent at longer-term interest rates. The best-case scenario for an mREIT is low short-term rates and high long-term rates; naturally, when those rates come closer together, mREITs suffer.
REITs also have their own funky taxation rules, but the broadest one is that REITs are typically taxed as ordinary income, which means the IRS will take its cut at your top marginal tax rate.
And lastly, a quarter of the fund is invested in the two aforementioned companies, NLY and AGNC, which is a scary amount of single- (well, double-) company risk.
High-Yield Index Funds: Market Vectors BDC Income ETF (BIZD)
Dividend Yield: 8.3%
Expense Ratio: 9.17%
If the expense ratio for the Market Vectors BDC Income ETF (NYSEARCA:BIZD) seems high for index funds — or any funds, really — it is, but it doesn’t tell the full story. More on that in a second.
BIZD invests in business development companies (BDCs), which are a special niche class of companies that help fund the development of small- and mid-sized businesses. These companies typically have more difficulty securing funds than larger companies with more resources and better debt ratings — and as a result, BDCs are able to charge a heck of a lot more.
Just like REITs, BDCs must pay out at least 90% of their profits in the form of dividends, so BIZD throws off a generous 8%-plus right now. But like mREITs, BDCs make money on the “spread,” borrowing at short-term rates and lending at the high rates necessary to back up their risks in funding smaller, often speculative companies. That means if shorter-term rates head higher or longer-term rates slump, mREITs can suffer.
Market Vectors’ fund, like REM, is also top-heavy in its holdings, with Ares Capital Corporation (NASDAQ:ARCC) and American Capital Ltd. (NASDAQ:ACAS) representing nearly a quarter of the fund’s weight.
And that expense ratio? It’s not as bad as it sounds.
BIZD currently charges just 0.4% in actual management fees. However, BDCs are essentially funds with their own operating expenses and fees — and because of that, BIZD must actually report those expenses, even though many of them are not actually being charged by the fund itself. Those expenses do end up coming out of performance — but from the individual-BDC-level returns, not the fund itself.
BIZD itself is actually a quality way to buy a basket of these high-yielding assets.
High-Yield Index Funds: PowerShares KBW High Dividend Yield Financial Portfolio (KBWD)
Dividend Yield: 8.6%
Expense Ratio: 1.55%
Now that we’ve covered mREIT and BDC index funds, let’s smash them together!
The PowerShares KBW High Dividend Yield Financial Portfolio (NYSEARCA:KBWD) is, as it sounds, a financials-heavy fund. But because we’re talking high yield, the “financials” here aren’t big banks like JPMorgan Chase & Co. (NYSE:JPM) … they’re mostly a mix of mREITs and BDCs, as well as traditional REITs.
Naturally, the big danger up front here is the interest-rate risk. Any narrowing of the spread isn’t going to work out well for KBWD.
Still, I particularly like KBWD for a few reasons.
For one, you’re clipping your asset-specific risk a bit by meshing the REITs and BDCs in one fund. And, because the concentration of BDCs is lower, you’re not losing as much in those operating expenses — while at the same time enjoying a slightly lower straight-up management fee (0.35%) than BIZD.
I also like the construction of this fund better, simply because it’s much more spread out. KBWD holds 37 companies, including the aforementioned American Capital Agency, Annaly Capital and Ares, but no one of them comprises more than 5% of the fund currently, and even the lightest holding still has a 1% weighting.
Lastly, KBWD pays out its dividends on a monthly basis, not quarterly, which can be a boon to many in retirement.
KBWD’s yield isn’t nearly as high as REM’s, sure, but if you’re being “conservatively aggressive” about it, I’ll take the relative safety any of KBWD any day.
High-Yield Index Funds: Yorkville High Income MLP ETF (YMLP)
Dividend Yield: 12.6%
Expense Ratio: 0.82%*
Master limited partnerships, or MLPs, deal in just a few businesses, mostly having to do with the production and transportation of natural resources like oil and natural gas. And many MLPs are involved in pipelines, so they simply make money when oil or gas pass through these pipes – leading many to refer to such MLPs as “toll takers.”
These partnerships produce cash flows that are then distributed back to unitholders (similar to normal stocks’ dividends), as well as their general partners. Thus, they have become one of Wall Street’s most beloved ways of picking up high yield.
The Yorkville High Income MLP ETF (NYSE:YMLP), which holds 25 MLPs dealing mostly in energy and materials, is among the highest-yield index funds dealing with MLPs, throwing off 12.6%. YMLP holds MLPs such as integrated propane firm NGL Energy Partners LP (NYSE:NGL) and EV Energy Partners, L.P. (NASDAQ:EVEP), an upstream (exploration and production) oil and gas company.
The dangers here?
Not all MLPs are so-called “toll takers,” so cratering energy prices can really take a toll on them. (In fact, even pipeline MLPs can fall victim to mistaken reactionary selling). To wit, last year’s summer energy selloff hit YMLP hard, with the fund currently down 20% from its July 2014 highs.
YMLP also has a bizarre tax twist.
MLPs themselves are a tax hassle, as investors must fill out special K-1 forms for their MLP holdings; the distributions ultimately affect the cost basis for purposes of reporting any capital gains from selling MLP units. Yorkville’s ETF is structured as a C-corporation, which means that YMLP has to deal with its holdings’ tax complexity — not you — but as a result of that C-corp structure, YMLP pays corporate taxes on any profits. Per The Motley Fool:
“The result is that MLP ETFs underperform the MLPs they own by roughly the percentage that goes to corporate-level taxes. Over the past several years, that has added up to huge shortfalls …”
In short: YMLP offers you an easy way to invest in a bunch of MLPs without dealing with K-1s, but you’re probably leaving some returns on the table in exchange.
* YMLP also charges for deferred income tax expenses, so the overall expenses of the fund aren’t just the 0.82% in management fees listed above, but an additional 3.83% of “Other Expenses.”
High-Yield Index Funds: Arrow Dow Jones Global Yield ETF (GYLD)
Dividend Yield: 7.5%
Expense Ratio: 0.75%
If KBWD was a mash-up, consider the Arrow Dow Jones Global Yield ETF (NYSEARCA:GYLD) the megamix.
The GYLD not only offers investors access to high-yield assets like MLPs and REITs, but it also can cover general dividend-paying stocks, preferred stocks, high-yield corporate debt and even high-yield sovereign debt. You can get just about anything in this fund – for instance, StoneMor Partners L.P. (NYSE:STON), an MLP that operates in the business of death. StoneMor Partners provides burial lots, crypts, grave markers and more across more than half the U.S., as well as Puerto Rico.
And, as its name would suggest, it’s also globally focused, with more than half of its stock portfolio based outside of North America, and only 37% of its bonds coming from the U.S.
GYLD is the most diversified of these funds, not just in what it covers, but its holdings – the index fund holds 90 stocks and 60 bonds. However, the fact that GYLD is so widespread in its assets and geography means there’s few big, single risks to look out for.
If you had to pick one thing to keep on your radar, it would be (big surprise) interest rates. Past the aforementioned risks involved with other REITs, there’s also the general rule that if investors can get better yields from safer sources such as Treasuries, they’ll start to abandon more risky sources of yield. Not to mention, rising interest rates theoretically should hamper the worth of GYLD’s current bond holdings.
And GYLD makes this more complicated in that you have to factor in not just U.S. debt, but other countries’ debt as well.
But GYLD’s income does plenty to offset bad times. For as mediocre as GYLD’s actual price movement has been since its May 2012 inception (it’s flat), it still boasts a total return of 20% over that time.
EDITOR’S NOTE: This has been edited to clarify GYLD’s returns.