Yield Alert: This ETF Pays a 12.6% Distribution

While your author is pretty much firmly cemented in the dividend growth camp, I also think that high-yield stocks get a bit of a bum rap.

Look at it this way. Say you’re a baller and you retire with $1M. You put it all into dividend growth stocks that yield an average of 4%, and generate $40,000 in annual income. Add that to your CPP, OAS, and a paid-off house, and retirement looks pretty sweet.

Now let’s assume that you make a small tweak to the portfolio. You keep $900,000 in dividend growth stocks and then move $100,000 into a few well-researched high dividend stocks that yield 7%. Suddenly, your total income is now $43,000 — or about 7% higher.

This one small move can make a real difference in an overall portfolio. The majority of the portfolio is still going to deliver dividend growth, but that small sliver of high yield exposure really increases total income. It’s a powerful combination.

Unfortunately, some folks take this too far. If a small raise in dividends is good, they counter, then a bigger raise must be even better. And so they stuff their accounts with the highest yielding stocks they can find. Their $1M portfolio suddenly generates six-figures in income, and they’re laughing all the way to the bank.

Sometimes such a strategy works, but most of the time it ends up being a loser. Dividends get cut, share prices follow, and retirements get wrecked.

With this in mind, let’s take a closer look at a popular ETF, the Hamilton Enhanced Mutli-Sector Covered Call ETF (TSX:HDIV), which currently pays a 12%+ yield. Is the payout sustainable?

The skinny

Let’s first take a closer look at this ETF. Just how does it generate a 12% yield, anyway?

According to the fund’s objective, it:

“…seeks to provide attractive monthly income and long-term capital appreciation from a diversified, multi-sector portfolio of primarily covered call ETFs focused on Canada.”

So, in short, the fund has investments in other covered call ETFs. It generates income from those products, plus it gets the underlying dividends.

But wait. There’s more. The ETF also maintains “modest cash leverage of 25% to enhance yield and growth potential.”

Here’s the portfolio in a nutshell. We’ll note that these numbers add up to more than 100% because of the leverage component.

The leverage doesn’t just stop there. Some of the ETFs top holdings (including the largest position) also use a 25% leverage to goose their returns.

The fund itself doesn’t have a management fee, but investors do pay the corresponding fees for the underlying investments. Most of these ETFs have fees in the 0.6-0.7% range. The interest on the leverage is also a fee, since it ultimately comes out of the bottom line.

On the plus side, the ETF has outperformed the TSX 60 since inception in 2021 — assuming all dividends were reinvested. This result is through March 31st.

Finally, assets under management are in the $600M range, and average daily volume is more than 100,000 shares per day. There’s enough liquidity here that you can get in and out of the stock quickly, if needed.

Distribution history

The first thing to look at with an ETF like this one is whether the company has paid a steady distribution throughout its history.

HDIV only has a few years behind it, so we should take those results with a grain of salt. It just doesn’t have the history of going through a full business cycle.

What we see is actually quite positive. The fund debuted in 2021 with an $0.1175 per share payout. The distribution has been hiked seven times since then, and now currently pays out $0.1725 per unit on a monthly basis. That’s a 47% increase in less than four years. 

I can see why people are impressed. There aren’t many Canadian stocks that can offer much better dividend growth.

Dividend investors — including yours truly — like to say that you can’t fake a dividend. You can get away with it for a little while, but eventually reality catches up to you. It’s only a matter of time.

In a situation like this one, I’m going to argue that it’s actually easier to fake a dividend, and that you can actually maintain it for a while. Assuming the market cooperates, that is.

Here’s how.

Checking under the hood

Essentially, what ETFs like this one do is they return an investor’s capital in the form of a dividend or a distribution.

This isn’t easy to identify unless you look into the fund’s financial statements. Many investors don’t bother doing this, since funds like this one are often diversified and ran by smart, qualified managers. That’s what the management fee is for, they argue.

When we do look under the hood, we discover a truth that most owners of the ETF don’t realize. This fund is paying back all the income it generates from the underlying investments, and then some. You’re getting your capital back as a distribution.

The evidence is all over these financial statements. Take note of the net assets per unit, which basically haven’t budged despite it (mostly) being a bull market between 2021 and 2024. But the especially damning part is the return of capital portion of the distribution.

From mid-2021 through 2024 — pretty much the fund’s entire history — it paid $5.77 per share in distributions. But $2 per unit (or 35% of total distributions) came from investors getting their own money back. A further $1.76 per share was from capital gains. Just $2.01 per unit actually came from the income this fund generated.

So what?

At this point, a common critique of this analysis goes something like this.

Nelly, why should I care? If you want to get technical, every dividend is just an investor getting their capital back.

The problem is such an argument doesn’t compare apples to apples. You’re comparing a traditional dividend-paying investment with something that pays a dividend and part of its capital back.

No wonder the latter can offer a better yield. The two investments aren’t even playing the same game.

The fact is I can easily create an investment that does the exact same thing as HDIV, and I don’t even need leverage to do it.

Let’s use one of my favourite high-yielders, First National Financial (TSX:FN) as an example. As I write this, First National offers a 6.3% yield. To create a 12% “dividend” just like HDIV does, I can simply sell 5.7% of my First National shares every year.

Boom. Easy.

(Astute readers will remember First National pays a special dividend most years. We’re going to assume that doesn’t exist for this exercise)

Some years this would turn out just fine. First National shares go up more than 5.7% and the entire investment ends up higher — even after taking out the 12% “dividend” I just created. 2019 is one example.

Other years this would be a terrible move. In 2022, for instance, First National shares fell by 20%. If I would’ve sold at the bottom, I would’ve increased that loss to more than 25%. Suddenly, I need a 33% return to get to break-even, rather than a 25% one.

Now let’s imagine a bear market that grinds slowly lower for three years — like we had from 2000 to 2003. A fund like this one isn’t going to have many gains. So it has two choices — it can either pay back its capital as distributions (which causes the share price to go down) or it can pay back significantly less income. If you’ve retired based on that income, you’re in trouble.

The point is this. You cannot compare this to a normal dividend stock. This one:

• Uses leverage

• Sells covered calls to generate additional income

• Returns capital to its owner each and every year

A regular dividend stock, meanwhile:

• Has no leverage

• Doesn’t employ covered calls (which, I’ll remind y’all, limit upside)

• Generates income from only the company’s internal earnings

No wonder it can offer a higher yield.

The bottom line

I don’t want to talk the thousands of Canadians who own this product — or one of many just like it — out of anything. The fact is this fund has paid an excellent dividend and grown the payout over time, and that’s worth something.

I’m mostly concerned with investors knowing what they’re getting into. The fact is a fund like this one does not pay the distribution from the income generated from the covered calls and the underlying dividends. It’s forced to sell shares each year to send out the door as dividends.

If a unitholder understands that and knows the risks, then by all means. Knock yourself out.

I’ve spoken to probably 100+ investors who own this fund (or one like it) and the vast majority of them don’t really understand what they’re getting into. That’s a problem.

There are covered call funds that do generate enough income to cover the distribution — but those tend to yield in the 5-7% range. That’s a far cry from 12%+.

You should be skeptical of any high yield stock, especially one that yields 12%. That includes funds like this one.

One more thing

Canadian Dividend Investing takes a closer look at high-yield stocks each and every week, giving Canadian savers the info they need to choose solid high-yielders with (relatively) low payout ratios.

We cover virtually all of Canada’s high yielders, and can tell you from experience some are far better than others. What we’re really after are what we call “accidental high yielders,” excellent stocks that are temporarily beaten up. That’s the time to buy — you want to lock in that yield while the opportunity is good, and then hold that stock for a very long time.

If you do it right, you’ll get a nice combination of dividend income and capital gains.

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