MDIV: Shrinking Income And Capital

Summary

  • MDIV is a high-yield ETF diversified in 5 categories of securities.
  • Since inception, the fund has lost about 17% in share price and 26% in annualized distribution.
  • How to manage capital decay in high yield securities.
  • Looking for a helping hand in the market? Members of Quantitative Risk & Value get exclusive ideas and guidance to navigate any climate. Learn More »

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Strategy and portfolio

The First Trust Multi-Asset Diversified Income Index Fund (NASDAQ:MDIV), is a high yield fund paying monthly distributions with a 12-month distribution yield of 5.49% and a net expense ratio of 0.61%. It was launched on 08/13/2012 and tracks the Nasdaq US Multi-Asset Diversified Income Index, a rule-based strategy mixing different categories of securities.

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

Equity securities (excluding REITs) must meet conditions of capitalization and liquidity, and show:

  • dividends paid each of the last three years,
  • positive total earnings in the trailing 12 months,
  • a dividend payout ratio no greater than 80%,
  • one year realized volatility below the Nasdaq Benchmark Index one-year realized volatility plus 15%.

Then, 50 stocks passing the 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 preferred stocks are ranked based on yield and volatility. The top 25 are included in the index and weighted by yield.

The screen for MLPs also drops the positive earnings conditions and follows the same principles with specific rules. It results in another group of 25 constituents.

Fund composition

Fund composition (source: FirstTrust)

Excluding the high yield bond ETF, the heaviest securities issuers in MDIV are AGNC Investment Corp (AGNC) with 2.66% and Citigroup Inc (C) with 2.41%. These weights combine several lines of securities for each company. As a consequence, risk exposure related to any individual company is limited.

Performance

Since inception in 2012, MDIV with dividends reinvested has lagged the S&P 500 by 9.7 percentage points in annualized return (see next table). Moreover, maximum drawdown and volatility point to a higher risk.

Total Return

Annual Return

Drawdown

Sharpe ratio

Volatility

MDIV

44.59%

3.83%

-46.59%

0.32

14.24%

SPY

247.94%

13.58%

-32.05%

0.97

13.65%

The next chart plots the equity value of $100 invested in MDIV and SPY since MDIV inception (dividends reinvested).

MDIV vs. SPY

MDIV vs. SPY (chart: author; data: portfolio123)

The annualized return reinvesting all distributions, without paying any tax on them, is below the distribution rate. This is a red flag pointing to capital decay. It is confirmed by MDIV share price history: it has lost about 17% since inception.

MDIV share price, without dividends

MDIV share price, without dividends (TradingView on SeekingAlpha)

Capital decay also means income stream decay: the yield cannot go up continuously to offset the loss in asset value. The annual sum of distributions went down from $1.18 in 2013 to $0.88 in 2021 (source). This is a loss of income stream of 26% in 8 years. Current inflation is an additional drag.

This issue is not specific to MDIV: securities paying yields above 6% suffer from capital decay, with rare exceptions. The 10-year average annualized return including dividends of all ETFs with a yield superior to 6% is 4.5%, for an average yield of 8.8%. The 10-year average annualized return including dividends of all Russell 1000 stocks with a dividend yield superior to 6% is 5.9%, for an average yield of 8% (data calculated with Portfolio123).

MDIV may be used as an instrument for swing trading or tactical allocation, but I don't recommend it as a long-term holding in a sustainable retirement plan. This is true for a number of high-yield instruments, not only this one.

How to manage capital decay in high yield securities

Capital and income decay is a structural issue in many closed-end funds, like in most high-yield instruments. However, it is not inexorable if one knows how to trade CEFs instead of using them as buy-and-hold instruments. I designed a 5-factor ranking system statistically related to forward returns across the full CEF universe, and started publishing the 8 best ranked liquid CEFs in Quantitative Risk & Value (QRV) after the March 2020 market meltdown. The list is updated every week. Its average dividend yield varies around 7-8%. It is not a model portfolio: trading the list every week is too costly in spreads and slippage. Its purpose is helping income investors find funds with a good entry point. In the table and chart 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 since then, ignoring intermediate updates to limit transaction costs. Returns are calculated with holdings initially in equal weights without rebalancing until the next 3-month update. Dividends are reinvested at the beginning of every 3-month period.

Since 3/25/2020

Total Return

Annual Return

Drawdown

Sharpe ratio

Volatility

Best 8 CEFs quarterly

147.32%

51.20%

-13.33%

2.38

16.80%

SPY

74.10%

28.81%

-18.22%

1.43

17.13%

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

This simulation is not a real portfolio and not a guarantee of future return (Data calculated with Portfolio123)

The usual disclaimer says that past performance (real or simulated) is not representative of future return. I go farther: the “Best 8” list has very little chance to perform as well in a future 2-year period as in the past 2 years. The March 2020 meltdown resulted in price dislocation and exceptional opportunities in the CEF universe. The 2022 downturn was also a source of opportunities in energy and infrastructure funds. This is unlikely to be reproducible in the future. However, I think a discount-driven rotational strategy in CEFs has a much better chance to protect both capital and income stream against erosion and inflation than any high-yield passive investment like MDIV. Dates and lists can be checked in QRV post history (trial is free).

In these uncertain times, Quantitative Risk & Value (QRV) provides you with risk indicators and data-driven, time-tested strategies. Get started with a two-week free trial now. 

This article was written by

Fred Piard profile picture
14.42K Followers
Data-driven portfolios and risk indicators.
Author of Quantitative Risk & Value and three books, I have been investing in systematic strategies since 2010. I have a PhD in computer science, an MSc in software engineering, an MSc in civil engineering and 30 years of professional experience in various sectors. My aim is making simple and efficient quantitative investing techniques available to my followers. Quantitative models can make investment decisions faster, reproducible and emotionless by focusing on relevant information in the middle of market noise. Moreover, models can be refined to meet specific risk tolerance and objectives. 

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I am an individual investor and an IT professional, not a finance professional. My writings are data analysis and opinions, not investment advice. They may contain inaccurate information, despite all the effort I put in them. Readers are responsible for all consequences of using information included in my work, and are encouraged to do their own research from various sources.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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