The 7% Yield Solution: A 4 ETF Portfolio That Offers Diversification, Risk Mitigation & High Yield

Investors don't necessarily need to venture that far out on the risk spectrum to capture a high yield.
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Many income seekers, including retirees, have resigned themselves to the fact that their portfolios just may never generate the kinds of dividends that they want them to. Both 10-year Treasuries and large-cap stocks yield less than 1.5%. If you target longer-term corporate bonds or high yield stocks, you may be able to achieve 3%. If you want a yield beyond that, you have to push further out on the risk spectrum into things, such as emerging markets bonds, MLPs and mortgage REITs. Those asset classes, of course, are much riskier and expose investors to significant downside risk, something many income seekers can ill-afford.

But all hope is not lost!

ETF issuers recognize the struggles of the current low yield environment and have developed solutions to address them. Several of the ETFs that have been launched over the past year or two are using some less conventional, more complex strategies in order to accomplish these goals, but if you dig into how they work, you'll find that they're structurally sound and actually do a reasonable job of creating a sustainable high yield without drifting too far out on the risk spectrum.

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There will be risks that come with investing in each of the ETFs I'll discuss here, as should be expected with any investment that yields around 7% in today's environment. When you consider them together as part of a single investment collectively, however, you'll find a relatively diversified portfolio that consists of large-cap stocks, some international exposure, a mix of investment-grade and high yield corporate and government bonds and a splash of alternative investments to diversify overall risk while providing a yield boost.

You won't find any names from the likes of Vanguard, State Street, BlackRock or Schwab here. We'll need to dig a little deeper into the ETF marketplace to find funds that fit what we're looking for here. Investors should still feel comfortable adding to their portfolios even though some are relatively new and less-known to the world.

Let's start by looking at the 4 ETFs individually and then we'll dive into how they look together.

Nationwide Risk-Managed Income ETF (NUSI)

Current Yield: 7.74%

Objective: An income solution that targets high current income and seeks to provide investors with a measure of downside protection in falling markets and potential for upside participation in rising markets.

source: ETF Action

source: ETF Action

I've written about this fund in the past and think it's one of the most interesting high yield opportunities available to investors today. NUSI starts with a core position replicating the Nasdaq 100 index. On top of that, it layers on an options collar strategy, which consists of two components. First is a covered call strategy in which the fund can write call options on up to 100% of the portfolio's holding in order to generate high income. Second is a protective put strategy in which the fund uses some of the premiums generated from the written calls in order to buy put options on the index that help mitigate downside risk.

The covered call positions end up limiting upside, but that's countered by the protective put limiting potential downside. The resulting portfolio ends up having lower volatility to both the upside and downside, but generates roughly an 8% distribution yield thanks to the net premiums received from the options activity.

How much less volatility? According to historical betas and standard deviations of returns, NUSI is about 50-60% as volatile as the Nasdaq 100 index. The COVID-19 recession in 2020 provided a good example of what kind of downside protection investors could expect. From peak to valley, NUSI experienced a max drawdown of around 10% compared to a nearly 30% correction in the Nasdaq 100.

JPMorgan Equity Premium Income ETF (JEPI)

Current Yield: 7.18%

Objective: Generates income through a combination of selling options and investing in U.S. large cap stocks, seeking to deliver a monthly income stream from associated option premiums and stock dividends.

source: ETF Action

source: ETF Action

JEPI is an actively-managed fund that you could consider as something of a hybrid between a traditional covered call ETF and a large-cap low volatility ETF. It has a bit of an unconventional structure, but the finished portfolio looks pretty traditional.

The fund can be broken down into two components - 1) an allocation to equity-linked notes that are designed to look and behave like an S&P 500 covered call strategy all within a single security and 2) an actively-managed segment that focuses on research, valuation and security selection that has a lower overall volatility than the S&P 500. Currently, about 16% of the fund's assets are invested in the ELNs with the remaining going towards the individual equity positions. While it doesn't have a target distribution yield, it has consistently paid an annualized rate of around 7-8% historically.

Even though its focus is mostly on the components of the S&P 500, JEPI, not surprisingly, has a higher correlation with not just the big low volatility ETFs, but also some of the bigger dividend growth ETFs, such as the Vanguard Dividend Appreciation ETF (VIG) and the WisdomTree U.S. Dividend Growth ETF (DGRW).

Strategy Shares Nasdaq 7HANDL Index ETF (HNDL)

Current Yield: 7.00%

Objective: The index invests a 50% allocation to fixed income and equity ETFs and a 50% allocation to a “Dorsey Wright Explore Portfolio,” a tactical allocation with U.S. fixed-income, U.S. blend, U.S. equity and U.S. alternative assets. It has a policy to pay monthly distributions of approximately an annualized 7.0% of the fund's net assets.

source: ETF Action

source: ETF Action

HNDL, which is a fund-of-funds, has a target distribution strategy that you often find in the closed-end fund universe. On the plus side, its policy of monthly distributions is a nice added bonus for income seekers, while the target yield offers a high degree of predictability. On the down side, the fund's distribution is dependent upon the performance of the fund. If the share price goes down, your dividend also goes down.

Just like the other funds mentioned above, HNDL also splits its portfolio into two pieces. The first is a "core" position, which includes broadly diversified equity and fixed income ETFs that would resemble a traditional diversified long-term portfolio using a 30/70 allocation. The second is the "Dorsey Wright Explore Portfolio", a tactical allocation with U.S. fixed-income, U.S. blend, U.S. equity and U.S. alternative assets, or categories that have historically provided high levels of income.

The fixed distribution strategy is the unique feature and must be watched closely because it has the potential to be good or bad. Because it aims to distribute an annualized rate of 7% of assets, HNDL needs to generate that type of total return in order for it to "stay above water". The fund will, of course, distribute any income that is generated, but any shortfall from the 7% target needs to be made up by the fund's net assets. That could include capital gains generated by the fund or what's considered a "return of capital", which is essentially returning the investor's initial investment. A distribution without the income/gains to support it can result in what's considered a "destructive" return of capital. Investors want to avoid destructive ROCs because they can erode the fund's asset base over time.

In HNDL's case, the returns of capital it has been making over time appear to be of the non-destructive variety and may actually be beneficial. Over its lifetime, HNDL's NAV has risen by 3%, which means the distributions are being supported. ROCs that are a return of the initial investment are actually non-taxable, so there's some benefit on that front as well.

GraniteShares HIPS U.S. High Income ETF (HIPS)

Current Yield: 8.20%

Objective: To provide a simple and diversified exposure to 4 alternative income categories - MLPs, REITs, BDCs and Closed-end funds - while paying a monthly distribution providing a regular and steady source of income.

source: ETF Action

source: ETF Action

Here's the non-traditional segment of the 4 ETF portfolio. The first three funds mentioned generally focus diversified portfolios of equities, fixed income and instruments that are tied to the most well-known indexes. HIPS is not that type of fund.

It invests in a mix of traditional high yield investments - REITs, MLPs, BDCs and closed-end funds. These are the types of products I mentioned earlier when talking about drifting far out onto the risk spectrum in order to capture a high yield. Used in moderation, they're perfectly fine to add as a satellite holding to a core portfolio. The low correlation to traditional asset classes actually ends up helping to reduce overall portfolio risk even though the individual components are riskier. You don't necessarily want to go overboard here since they will make the overall portfolio riskier when added beyond a certain point, but modest use has benefits.

The 7% Yield Portfolio

Let's take a look at the 4 ETFs side-by-side along with their yields and allocations I've chosen before discussing why I set it up this way.

source: fund websites

source: fund websites

Each of these components currently yields 7% or more on a forward-looking basis (HNDL's yield fluctuates a little based on current share price movements, but I'm using the 7% target here). Those yields can and do change over time based on prevailing market conditions, so these numbers need to be monitored for movements both higher and lower.

I've given allocations to the three "core" ETFs - NUSI, JEPI and HNDL - of between 25-35%. NUSI gets the smaller 25% allocation because it's focused on the narrower Nasdaq 100 instead of the broader market. The other funds have their own allocations to the tech space and giving any larger weighting to NUSI could seriously overweight the overall portfolio towards tech stocks. As we'll see in a moment, the overall mix has an allocation to tech that's comparable to the broader market, so this seems like the right call.

JEPI almost entirely consists of S&P 500 stocks and has a bit of a lower volatility tilt, something that could be important for those relying on their portfolios for regular income, so it gets a slightly higher allocation. HNDL offers a nice diversified mix of stocks, bonds and alternatives, so its allocation falls between the two. HIPS is strictly a satellite to the core portfolio positions, so a 10% weighting feels about right.

Since all of these funds currently yield 7% or higher, you can feel free to play around with the individual allocations to suit your personal needs while still being able to achieve the 7% yield goal.

Portfolio Composition

As constructed, the 4 ETF portfolio consists of around 70% equities, 21% fixed income and 9% that's categorized as "other" or cash. 85% of the equity holdings fall into the large-cap bucket.

source: Portfolio Visualizer

source: Portfolio Visualizer

If there's one drawback to this portfolio, it's that it's heavily weighted towards U.S. large-cap stocks. Less that 3% overall goes towards international stocks and just over 3% to international bonds. To many investors, that may not matter since U.S. investments have done so much better than foreign investments over the past decade. Over time, there are still extended periods where international outperforms and there will be again. When that happens, this portfolio could be poorly positioned for such a transition.

While tech, not surprisingly, accounts for the largest percentage of this portfolio at more than 25% of assets, there are 7 distinct sectors which receive allocations of at least 8%. This offers investors a really nice diversified mix of different exposure that could benefit in multiple market environments.

source: Portfolio Visualizer

source: Portfolio Visualizer

The fixed income component looks a little less diversified. It's heavily allocated to non-investment grade bonds, which could be troublesome given where yields/spreads currently stand in consideration of overall market and political risks.

source: Portfolio Visualizer

source: Portfolio Visualizer

The overall duration of the fixed income portion is around 5-6 years, so this is fairly in line with what you'd expect from an intermediate-term bond portfolio. There's some risk here since yields have almost nowhere to go but up, but I don't view interest rate risk is a major concern here.

Conclusion

A challenging yield environment calls for unconventional portfolio solutions. The natural inclination for many investors might be to just dive into REITs or MLPs like everyone else or consider closed-end funds, which almost exclusively focus on high yields. Those assets, of course, come with high risk in exchange for those high yields. That might be something investors can ill-afford with equities still pushing all-time highs, the Fed getting ready to taper, the economy slowing and the delta variant adding another unknown to the equation.

Fortunately, there is still a way to achieve a high yield while maintaining diversification and not venturing too far out on the risk spectrum. This portfolio focuses mostly on lower volatility equities, risk-mitigated strategies and fixed income, so it still has the look of a traditional portfolio allocation in the pursuit of high yield. Better yet, it comes in a simple package of 4 ETFs, so there's not the need to add fund on top of fund in order to spread out risks.

There are some risks here. The low asset base of HIPS runs the risk of having to deal with higher trading costs. JEPI is just over a year old, although it has amassed an impressive $3 billion in assets over that short time. HNDL's distribution is dependent on the fund's performance, so a downturn could result in a destructive return of capital.

There will always be risks in trying to achieve a high yield in this environment. This combination of high yield ETFs should do a solid job of providing diversification and risk mitigation while allowing income seekers to start collecting some larger checks.

source: ETF Action

source: ETF Action

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