The competition among ETF issuers to maximize income from stock portfolios has expanded with the introduction of a new fund from Pacer. On Tuesday, the firm launched the Pacer Metaurus Nasdaq-100 Dividend Multiplier 600 ETF (QSIX), a companion to the US Large Cap Dividend Multiplier 400 ETF (QDPL), which has accumulated over $500 million in assets since its inception in 2021. These funds aim to produce distributions that are six times the dividend payouts of the Nasdaq-100 Index and four times those of the S&P 500, respectively.
Income strategies have seen significant growth in the ETF sector in recent years, with covered call funds becoming particularly popular. Global X covered call ETFs on the S&P 500 (XYLD) and Nasdaq-100 (QYLD) have amassed more than $10 billion in combined assets, according to FactSet. Additionally, JPMorgan’s Premium Income ETFs—JEPI and JEPQ—employ a variation of the covered call strategy and collectively hold over $50 billion in assets.
A potential drawback of covered call funds is the limitation they place on portfolio upside for the portion covered by the call option. According to Sean O’Hara, President at Pacer ETF Distributors, the Pacer funds are designed to capture more upside during market rallies. The QDPL fund, for instance, has approximately 89% of its exposure to S&P 500 stocks, with the remaining portion allocated to trading dividend futures to generate additional income. Unlike covered call funds, there is no hard cap on the upside for the equity portion.
The QSIX fund follows a similar strategy but focuses on Nasdaq-100 stocks. The Pacer funds replicate the holdings of the underlying equity index while also taking long positions on dividend futures contracts covering the next three years. The ratio of equity exposure to dividend futures exposure is adjusted during the annual rebalance to achieve the target multiplier for distributions, said O’Hara. By holding all index stocks, these funds aim to mitigate the sector and style risks associated with funds that solely invest in dividend-paying stocks.
Over the past three years, the QDPL fund has outperformed several popular dividend-focused funds, such as 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 annual total dividends paid by a group of stocks, designated as “points” by S&P Dow Jones Indices. These futures contracts essentially bet on the total points by a specified date, according to CME Group.
The Pacer funds generate income from three distinct sources, which can impact after-tax returns. For 2023, Pacer estimated that QDPL’s income consisted of 23% from S&P 500 dividends, 8% from capital gains on futures contracts, and 69% as a return of capital. The QDPL website currently shows a distribution yield of 5.79%, significantly higher than the approximate 1.3% dividend yield of the S&P 500, as indicated by YCharts.com. However, the 30-day SEC yield, which excludes return of capital from futures contracts, is 1.01%. In contrast, JEPI, which generates income primarily from fees earned by writing call options, has a 30-day SEC yield exceeding 7%.
A potential advantage of the Pacer funds is that the return of capital portion may not count as taxable income. The downside, however, is that this return of capital is essentially a return of the principal and could lead to asset shrinkage, potentially affecting long-term performance. O’Hara explained that capital gains from dividend futures arise because these contracts are often priced at a discount to projected payouts, compensating investors for risk. Additionally, dividend futures could see larger gains if more companies in the index start paying dividends. Notably, major Nasdaq companies like Amazon and Tesla currently do not pay dividends. However, recent moves by companies like Meta Platforms to start dividend payments could signal future trends.
It is important to note that dividend futures contracts could also decrease in value during economic downturns. For example, many companies, including major banks, suspended their dividends during the Covid-19 pandemic.