MDIV: 6.5% Yield ETF With Red Flags (NASDAQ:MDIV)

Strategy and portfolio

The First Trust Multi-Asset Diversified Income Index Fund (NASDAQ:MDIV), is a high-yield ETF with a 12-month distribution rate of 6.49%, a net expense ratio of 0.69%, and 126 holdings. It pays monthly distributions. It was launched on 08/13/2012 and tracks the Nasdaq US Multi-Asset Diversified Income Index, a rule-based model 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% 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:

• 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 150% threshold for the payout ratio. The index selects 25 REITs and weights them by yield.

Preferred stocks must pass a similar screen, without positive earnings conditions and with lower requirements in capitalization and liquidity. They are ranked based on yield and volatility. The top 25 are included in the index and weighted by yield. MLPs have similar rules, with specific parameters. They also result in 25 constituents.

Excluding the high-yield corporate bond ETF weighting 20.4% of asset value, the top 10 holdings are listed below.

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Several holdings in the preferred category may be issued by the same company. The top 3 issuers are AGNC Investment Corp. (AGNC) with 2.47% of the fund’s asset value, Citigroup Inc. (C) with 2.34%, and DigitalBridge Group Inc. (DBRG) with 2.27%. It is noteworthy that three of the four REITs in this table are mortgage REITs.

Performance

Since inception in 2012, MDIV with dividends reinvested has lagged the S&P 500 (SPY) by 9.5 percentage points in annualized return, and a 60/40 portfolio by 5.1 percentage points. Volatility is similar to the stock benchmark, but the maximum drawdown is deeper. The risk-adjusted performance (Sharpe ratio) is inferior to both benchmarks.

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The next chart compares MDIV with two other multi-asset high-yield ETFs: the GraniteShares HIPS US High Income ETF (HIPS), reviewed here, and the Global X Alternative Income ETF (ALTY), reviewed here. These products are MDIV 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. The chart starts on 8/1/2015 to match inception dates.

MDIV is the worst performer by a short margin. It is also less volatile. However, in the last 12 months, MDIV beats its competitors:

The annualized return since inception, reinvesting distributions, is below the distribution rate. This is a red flag pointing to capital decay. As of writing, MDIV share price has lost 24% since inception.

Moreover, the annual sum of distributions went down from $1.18 in 2013 to $0.88 in 2021 (source). For shareholders, it means a loss in annual income of 26% in 8 years. 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. In fact, most high-yield funds are in this case.

How to manage capital decay in high-yield securities

Capital and income decay is an issue in many closed-end funds, like in high-yield ETFs. However, it can be avoided or mitigated by rotational strategies, instead of using funds as buy-and-hold instruments. 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. Its average dividend yield varies around 7%. It’s not 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 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. Return is calculated with holdings in equal weights and reinvesting dividends at the beginning of every 3-month period.

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Of course, past performance (real or simulated) is not representative of future return. The “Best 8” list is unlikely to perform as well in the near future as since March 2020. The 2020 meltdown and 2022 volatility resulted in price dislocations and exceptional opportunities in the CEF universe. 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 passive investment.