Authors: Matthew J. Patterson & David I. Cohen1
Founders, Bryant Avenue Ventures ("BAV")
"What the world needs is real solutions for people who are in the drawdown portion of their investment life."2
Investors need income
Ten thousand people a day retire and need a steady, dependable and consistent distribution from their investment portfolios. In an era of low interest rates, few investors have sufficient retirement savings to live off the income produced by a portfolio of low-risk bank deposits and Treasuries. Investors can address this shortfall by reaching down the scale of fixed-income credit quality (to aptly named "junk" bonds) or through exposure to high-volatility, high-yielding alternative asset classes. While either of these options can produce modestly higher levels of current income, both come at a cost of significantly increased volatility and neither addresses the reality that retirees require high-distribution solutions that minimize the risk of idiosyncratic market dislocations.
Bryant Avenue Ventures and Nasdaq Global Information Services created Nasdaq HANDLS™ (High-Distribution AND Liquid Solutions) Indexes to address the income needs of retirees in the drawdown phase of their investing lives. The Nasdaq HANDLS indexing solution consists of three critical components:
- A well-diversified, multi-asset portfolio of low-cost exchange-traded funds (ETFs) that seeks to maximize risk-adjusted return.3
- The use of low-cost (compared to retail margin debt) leverage consistent with investor risk preferences to enhance the total return of the underlying portfolio
- A high managed distribution rate that seeks to monetize the expected total return of the leveraged portfolio over time
Introducing Target Distribution Indexes
Nasdaq HANDLS represent a new indexing category called Target Distribution Indexes. The Nasdaq 7HANDL Index was specifically developed with the goal to support, from total return, a 7 percent distribution rate, net of estimated expenses, after incorporating 23 percent structural leverage. Nasdaq HANDLS Indexes seek to employ well-diversified, multi-asset portfolios and the modest use of leverage to deliver total returns over time sufficient to support the target managed distribution rate of each Nasdaq HANDL Index.
By employing a well-diversified, multi-asset portfolio of low-cost ETFs, Nasdaq HANDLS Indexes rely upon the teachings of modern portfolio theory, which suggest that investors can employ diversification to reduce the level of idiosyncratic risk posed by individual investments in their portfolios. By reducing or eliminating such security-specific risk, diversified portfolios can earn higher risk-adjusted returns than undiversified portfolios. The use of low-cost ETFs ensures that the benefits of diversification are not subsumed by the cost of obtaining exposure to different asset categories and investments.
The second component of the Nasdaq HANDLS indexing solution — the use of modest leverage consistent with investor risk preferences — is similarly based on the teachings of modern portfolio theory. While investors should be aware that the use of leverage increases the expected return of a given portfolio (assuming the portfolio's unleveraged expected return is higher than the cost of leverage), it also increases the expected volatility, or risk, of the portfolio. One of the key insights of modern portfolio theory is that investors seeking more risk can earn higher risk-adjusted returns by leveraging a well-diversified portfolio than by investing in a portfolio that concentrates its investments in riskier assets. Moreover, few individual investors have access to low-cost forms of portfolio leverage or wish to deal with the administrative headaches of opening a margin account. Packaged solutions that provide them with access to low-cost leverage — either through portfolio securities lending or low-cost institutional bank credit lines — provide a genuine economic benefit.
The final component of the Nasdaq HANDLS indexing solution is a high managed distribution rate that seeks to systematically monetize the expected total return of a leveraged portfolio over time. This responds to the needs of retirees in the drawdown phase of their lives who require distributions that exceed the interest and dividend income earned by a balanced portfolio using modest leverage. Of course, there can be no guarantee that a given Nasdaq HANDLS index will earn a sufficient total return over time to support its target distribution rate. Nevertheless, most retirees will need to draw down their principal to fund their desired lifestyles in retirement. The Nasdaq HANDLS indexing solution eliminates the need for such investors to make regular piecemeal sales of investments to generate cash flow and offers the potential to earn a total return that fully supports a consistent, high distribution over time.
A better alternative to closed-end funds
Investors have historically relied upon closed-end funds (CEFs) to gain exposure to leveraged income-oriented portfolios that pay high managed distributions. CEFs, like mutual funds and ETFs, are investment management companies that pool together investor assets to be managed by a registered investment adviser. Unlike mutual funds and ETFs, however, CEFs issue a fixed number of shares that typically trade on a securities exchange. While mutual funds and ETFs allow for shares to be created or redeemed at net asset value (NAV), the prices of CEF shares are determined by market forces and may vary dramatically from their underlying NAV.
As of the end of 2016, investors held $262 billion in CEFs, with most of these assets in income-oriented strategies that use reasonable levels of leverage to enhance returns and pay high distributions. CEFs have also proven popular in other formats, serving as underlying investments in a variety of fund-of-fund investment products, including unit investment trusts, mutual funds, ETFs and exchange-traded notes. ETFs that invest in CEFs represent a nearly $1 billion category alone.
Unfortunately for investors, CEFs come with drawbacks, including high costs, lack of transparency and excessive premium / discount volatility. The Nasdaq HANDLS indexing solution offers an alternative to investors seeking high distributions who wish to avoid the shortcomings of CEFs.
For a variety of reasons, including less economic scale and an emphasis on active money management, CEFs tend to have higher management fees and expenses than mutual funds and ETFs. These fees and expenses reduce investor returns and offset the benefits offered by leveraged-income investment strategies. Funds that invest in CEFs — whether they be UITs, mutual funds or ETFs — incorporate the high fees and expenses of CEFs and add on additional fees and expenses. Consider the embedded fund fees and expenses and total expense ratios of the three largest ETFs that invest in CEFs:
The Nasdaq HANDLS indexing solution addresses the high fees of CEFs by adding leverage to a portfolio of low-cost, highly liquid ETFs to deliver a CEF-like investment experience without the associated high costs. For example, the embedded fund fees in the Nasdaq 7HANDL Index, after accounting for 23 percent leverage, average just 23 bps. While leverage, management fees and other costs add additional expenses, it is expected that investment products based on the Nasdaq HANDLS indexing solution will carry significantly lower total expense ratios than CEFs or other funds that invest in CEFs.
A second drawback of CEFs — which mutual funds also share — is that they are only legally required to report their holdings on a quarterly basis. This lack of transparency makes it difficult for financial advisors and investors to ascertain their investment exposure on a real-time basis. The Nasdaq HANDLS indexing solution addresses this lack of transparency by including only ETFs that disclose their holdings daily. And because each Nasdaq HANDLS Index provides exposure to a multi-asset portfolio of ETFs containing thousands of securities, investors minimize the idiosyncratic risk of fund managers making concentrated bets without their knowledge.
Perhaps the most pernicious drawback of CEFs concerns their pricing mechanism, which relies upon market forces to determine the value of CEF shares as they trade hands in negotiated transactions. Because CEF shares, under normal circumstances, can neither be created nor redeemed at their NAV, their actual market price may vary significantly from their NAV. While it is possible for a CEF to trade at a premium to its NAV, most CEFs trade at a discount to NAV.4
Savvy investors may see opportunity in CEFs trading at a discount to NAV, but should also consider that the CEF pricing mechanism adds an additional layer of volatility to their investments. Such additional volatility reduces risk-adjusted returns. The Nasdaq HANDLS indexing solution addresses this drawback by providing exposure only to ETFs that allow for creations and redemptions, which reduces the risk that the market price of an ETF share will deviate from its NAV. By dramatically reducing premium / discount volatility, the Nasdaq HANDLS indexing solution helps investors to earn better risk-adjusted returns than if they gained the same investment exposure through a CEF or a fund that invests in CEFs.
The Nasdaq 7HANDL Index is a 100 percent rules-based index defining a diversified portfolio of exchange-traded funds that has historically produced high risk-adjusted returns as defined by the Sharpe Ratio. The Nasdaq 7HANDL Index was specifically developed with the goal to support, from total return, a 7 percent distribution rate, net of estimated expenses, after incorporating 23 percent structural leverage. Accordingly, returns for the index are calculated assuming leverage on the underlying portfolio in the amount of 23 percent (net of the estimated cost of employing such leverage). The Nasdaq 7HANDL Index has risk characteristics similar to the broad U.S. capital markets and can be expected to generally rise and fall with prevailing market conditions.
The Nasdaq 7HANDL Index is split into two components, with a 50 percent allocation to a Core Portfolio and a 50 percent allocation to a Dorsey Wright Explore Portfolio.
The Core Portfolio embeds a long-term foundation by providing beta exposure to the U.S. fixed-income and equity markets. Allocations for the Core Portfolio are fixed at 70 percent U.S. aggregate fixed-income and 30 percent U.S. large cap equity. Chart 1 illustrates 30 years of historical performance for such a portfolio, assuming 23 percent leverage, and compares it to the performance of 100 percent equity and 100 percent fixed-income portfolios, in each case assuming a 7 percent annual distribution payout. The volatility of the 100 percent equity portfolio presents a potentially catastrophic risk of loss to investors in the drawdown portion of their investment life. In contrast, a 100 percent fixed-income portfolio is much less volatile but demonstrates a persistent inability to support a 7 percent distribution, particularly during periods of low interest rates. By comparison, the levered 70/30 (bond/stock) portfolio supported a 7 percent distribution rate over the long-term by smoothing out performance and delivering superior risk-adjusted returns.
Chart 1 Thirty years of asset class performance.
The Nasdaq Dorsey Wright Explore Portfolio component of the Nasdaq 7HANDL Index employs a 100 percent rules-based proprietary tactical asset allocation methodology to provide exposure to ETFs across a range of asset categories that have historically provided high levels of current income. The 12 asset categories represented in the Explore Portfolio include the following:
Table 1 Nasdaq 7HANDL Dorsey Wright Explore Portfolio Asset Categories
Each asset category in the Explore Portfolio is represented by a single ETF.5 The 12 ETF representatives of the Explore Portfolio asset categories are weighted on a monthly basis using a tactical asset allocation methodology developed in consultation with Nasdaq Dorsey Wright Investment Research & Analysis that seeks to incorporate momentum, yield and risk.6 Table 2 2017 Nasdaq 7HANDL Index Constituents Due to data limitations posed by the inception dates of ETFs included in the Dorsey Wright Explore Portfolio, back tested performance data on the Nasdaq 7HANDL Index is available from April 1, 2009 through the inception date of the index on October 12, 2017. As would be expected during a period of generally rising equity markets, the Nasdaq 7HANDL Index delivered a total return lower than equities and higher than bonds over this period. More importantly, it did so while providing superior risk-adjusted returns as measured by the Sharpe Ratio. Of perhaps greater interest to investors seeking income, the performance of the Nasdaq 7HANDL Index also compares favorably to other asset categories that investors might use for delivering high income.9 The superior risk-adjusted performance of the Nasdaq 7HANDL Index compared to other niche income categories demonstrates that investors seeking more risk and income may be better served by leveraging a well-diversified portfolio than by taking on concentrated risk. The risk-adjusted performance of the Nasdaq 7HANDL Index compared to ETFs that track composite indexes of CEFs validates the hypothesis that the pricing structure of CEFs and the associated premium / discount volatility reduces risk-adjusted returns. While both the Nasdaq 7HANDL Index and ETFs of CEFs provide leveraged exposure to well-diversified, balanced portfolios and deliver similar nominal performance, the ETFs of CEFs do so with much greater volatility and therefore earn significantly lower risk-adjusted returns. The Nasdaq HANDLS™ indexing solution offers investors CEF-like investment exposure without the drawbacks of CEFs. The final chart presents the impact of paying a 7 percent managed distribution (0.58 percent per month) on the Nasdaq 7HANDL Index compared to various alternative income-oriented investments. The Nasdaq 7HANDL Index achieved a superior profile in terms of volatility as measured by standard deviation, experienced smaller drawdowns than any of the three alternatives and was the only option that earned a total return sufficient to fund a 7 percent managed distribution. The Nasdaq HANDLS™ indexing solution uses the teachings of modern portfolio theory to deliver income-oriented investment solutions to investors in the drawdown portion of their investment lives. By building well-diversified, balanced portfolios of low-cost ETFs and using moderate amounts leverage to achieve enhanced returns, investors seeking income can minimize idiosyncratic risk posed by concentrated investments and earn higher risk-adjusted returns. High managed distribution rates provide an additional benefit to investors in the drawdown portion of their investment lives by minimizing the need to manage cash reserves and make piecemeal asset sales to finance lifestyle needs. Nasdaq HANDLS™ Indexes represent a new way to income for retirees. 1 The authors of this article have created or co-created ETFs that have raised approximately $14 billion in assets under management, including various first-to-market concepts (multi-asset income, BRIC, frontier, solar, timber, insider-activity, spin-off and shipping) and the popular BulletShares franchise. 2 "Rethinking 'Fixed Income,'" Dave Nadig, ETF.com (available at http://www.etf.com/publications/etfr/rethinking-fixed-income). 3 "Risk-adjusted return" is an adjusted measure of an investment's return that considers how much risk was involved in producing the return, usually using volatility over time to measure the riskiness of the investment. The most common measure of risk-adjusted return is the Sharpe Ratio. 4 According to the Investment Company Institute, the average discount to NAV for domestic taxable bond CEFs was 8.2% and 4.7% at year-end 2015 and 2016, respectively. 5 By default, the ETF representative of an asset category is the largest ETF (by assets under management) in the asset category. In certain circumstances, an alternative ETF with a lower expense ratio may instead serve as the ETF representative of an asset category. 6 The Explore Category allocation uses a proprietary methodology developed by Nasdaq Dorsey Wright (DWA). The 12 ETFs comprising the Dorsey Wright Explore Category are weighted based on the DWA Managed Momentum Score which is calculated as Relative Strength Weighting multiplied by Yield to Risk Weighting and rebased proportionally to 100 percent in order to calculate the Index Weight. 7 Estimated number of non-overlapping constituents that make up the underlying ETFs that serve as Nasdaq 7HANDL Index constituents. 8 The Sharpe Ratio is a measure of risk-adjusted return. It is calculated by dividing an investment's excess return by its standard deviation. An investment's excess return is determined by subtracting the return on a risk-free asset (generally, U.S. treasuries) from the investment's total return. The higher an investment's Sharpe Ratio, the better its returns have been relative to the amount of investment risk it has taken (using standard deviation, a measure of volatility, to measure investment). 9 PowerShares Buy Write (PBP), Alerian MLP ETF (AMLP) and the SPDR Bloomberg Barclays High Yield Bond ETF (JNK), iShares US Preferreds (PFF), PowerShares Senior Loan (BKLN). For more information, please contact Matthew Patterson, Cofounder, HANDLS™ Indexes at matt@handlsindexes.com. Nasdaq® is a registered trademark of Nasdaq, Inc. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Neither Nasdaq, Inc. nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding Nasdaq-listed companies or Nasdaq proprietary indexes are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED. © 2017. Nasdaq, Inc. All Rights Reserved.
When combined, the Core Portfolio and Nasdaq Dorsey Wright Explore Portfolio provide a balance between long-term and short-term investment strategies across a group of constituents whose underlying securities total an estimated 20,000 individual CUSIPS7.
