These funds multiply the market’s dividend yield. How they stack up

The competition among ETF issuers to find a new way to squeeze the most income out of stock portfolios expanded again on Tuesday, with a new fund from Pacer that aims to deliver amplified dividends. The firm launched the Pacer Metaurus Nasdaq-100 Dividend Multiplier 600 ETF (QSIX) , a sister fund to the US Large Cap Dividend Multiplier 400 ETF (QDPL) that has grown to more than $500 million in assets since its launch in 2021. The funds target distributions equal to six times the dividend payouts on the Nasdaq-100 Index and four times the S & P 500 dividend, respectively. Income strategies have become a huge area of growth for ETF issuers in recent years, with covered call funds arguably the most popular niche. Global X covered call ETFs on the S & P 500 ( XYLD ) and Nasdaq-100 ( QYLD ) now have more than $10 billion in combined assets, according to FactSet. And JPMorgan’s Premium Income ETFs — JEPI and JEPQ , which employ a variation of the covered call strategy — have more than $50 billion combined. A potential negative of covered call funds is that they put a hard cap on the upside of a portfolio for the portion that is “covered” by the call option. The idea behind the Pacer funds is that the funds will capture more of that upside during market rallies, according to Sean O’Hara, president at Pacer ETF Distributors. The QDPL, for example, currently has about 89% of its exposure to the stocks in the S & P 500, with the rest used to trade dividend futures to find more income, according to the fund’s website. There is not a hard cap on the upside for the equity portion. “What we’re looking to do is to get a total return that’s close to the S & P 500, with a cash flow that is exactly four-times whatever the dividend yield is on the S & P 500,” O’Hara said of the QDPL. The QSIX is similar but focused on Nasdaq-100 stocks instead. The Portfolio The Pacer funds mimic the holdings of the underlying equity index while also buying long positions on dividend futures contracts that cover each of the next three years. The ratio of equity exposure to dividend futures exposures is adjusted at the annual rebalance to best achieve the target multiplier for distributions, O’Hara said. By holding all the index stocks in the portfolio, the funds hope to avoid some of the sector and style risks that come with funds that just buy stocks that pay dividends. “You’re typically going to own a lot of financials, a lot of utilities, a lot of real estate. And typically those sectors don’t exhibit a lot of earnings growth,” O’Hara said of funds that focus only on dividend-paying stocks. Over the past three years, QDPL has outperformed several popular dividend-focused funds, including the ProShares S & P 500 Dividend Aristocrats ETF (NOBL) and Schwab US Dividend Equity ETF (SCHD) on a total return basis, according to FactSet. However, it has underperformed the Vanguard Dividend Appreciation ETF (VIG) . Dividend futures are based on indexes that track the total dividends paid over the course of the year for a group of stocks, designated as “points” by S & P Dow Jones Indices. The futures contracts are effectively a bet on what the total points will be by the stated date, according to CME Group . Income details The cash distributed by income ETFs is not created equal, however, and investors should be aware of how they differ and the potential impacts on their annual tax bill. For example, the income generated by the Pacer funds comes from three separate areas, which can affect the after-tax return. For 2023, Pacer estimated that the QDPL fund’s income boiled down to 23% from S & P 500 dividends on the underlying holdings, 8% capital gains from the futures contracts and 69% return of capital. The QDPL’s website currently shows a distribution yield of 5.79%, or more than four-times the roughly 1.3% dividend yield on the S & P 500, according to YCharts.com. However, the fund’s 30-day SEC yield — which does not include the return of capital from the futures contracts — is 1.01%. By comparison, JEPI generates much of its income from fees earned by writing call options, and it has a 30-day SEC yield above 7%. One potential positive is that the return of capital portion from the Pacer funds may not count as taxable income. The downside is that it is not necessarily new cash, but just a return of the principal of the fund and could lead the assets under management to shrink. That in turn could potentially hurt long-term performance. The capital gains from the dividend futures comes from the fact that the contracts are often priced at a discount to projected payouts, to compensate investors for risk, according to O’Hara. The dividend futures could also see bigger gains if more companies in the index decide to start paying dividends. “The big names in the Nasdaq, for the most part, don’t currently pay dividends,” O’Hara said, which means there could be upside captured if some of those names, like Amazon or Tesla , suddenly announce payouts. As a possible harbinger, Meta Platforms started first pating a dividend last March. Apple started paying a dividend in 2012 and Microsoft in 2003. To be sure, the dividend futures contracts could also decrease in value during times of economic stress. For example, many companies suspended their dividends during the Covid-19 pandemic, including several major banks.