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Income-Generating ETFs Popular in Tough Market

By Dinah Wisenberg Brin

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What You Need to Know

  • Investors are selling overpriced, actively managed funds and buying into cheap index ETFs, Dave Nadig says.
  • ETFs featuring dividend strategies, munis and high-yield bonds have seen strong inflows, he says.
  • Nadig warns that some ETFs are high risk.

Exchange-traded funds have been enjoying massive inflows in a year marked by high inflation and a bear market, with income-producing ETFs drawing significant investor interest.

ETFs are now the vehicle of choice for most active investors and are becoming the default choice for most long-term investors as well, according to Dave Nadig, financial futurist at research and consulting firm Vetta Fi.

The $6.6 trillion ETF industry in the U.S. has seen $375 billion in net inflows this year during the worst financial market in decades, and the funds are flowing across the board, including billions of dollars in positive inflows into equities, commodities, currencies and alternatives, he told ThinkAdvisor recently.

“It’s been one of the circumstances where the entire ETF universe has caught a bid,” Nadig said.

People see underperforming, overpriced active mutual fund managers, “they finally capitulate, they sell and where do they put that money? They put it into very cheap, very boring ETFs,” he said.

In a high-inflation environment, “income is really the place where people have been headed,” Nadig said in an interview, noting the launch of many income-focused ETFs this year. One of the best, the JPMorgan Equity Premium Income ETF (JEPI), generates “a monster yield” using dividend-paying stocks and options, Nadig said.

“That hunt for income, we’ve seen it in dividend strategies, we’ve seen it in munis, we’ve seen it in high-yield bonds,” he said. Real estate ETFs, like the Vanguard Real Estate Index Fund (VNQ), also have attracted inflows, he noted.

“Anything that’s throwing off income” is drawing inflows, Nadig said, noting that people flood to quality during big drawdowns.

Many advisors and investors see dividend payers — and specifically dividend payers with long track records of maintaining and growing dividends — as the highest quality part of the U.S. stock market, so they are often used as a quality proxy, he noted.

The most popular ETFs include “big, boring equity funds” offering “big, cheap beta,” like the SPDR S&P 500 Trust (SPY); the tech-oriented Invesco QQQ ETF (QQQ), which tracks the Nasdaq 100 Index; and the Vanguard Total Stock Market Index Fund ETF (VTI), he said.

“It’s pretty straightforward stuff that we’re all very familiar with,” Nadig said.

(Another consulting firm, ETFGI, recently reported that fixed income exchange-traded products saw nearly $27 billion in net inflows in July alone, for nearly $93 billion year to date. The firm noted that ETFs overall have experienced their second-highest net inflows on record year to date.)

ETF flows mirror what investors see in the broader mutual fund and underlying stock markets, he noted.

It’s important to remember that the ETF is just a wrapper that doesn’t necessarily make for a safer investment, Nadig said. There are incredibly safe ETFs that hold cash and “phenomenally risky” ones in which investors theoretically can lose all their cash in one day, he added.

“The wrapper is the wrapper, and the risk comes from what’s inside,” he said.

While it’s rare to find ETFs in 401(k) plans, ETFs make attractive targets for retirees rolling cash out of those plans and looking for new places to invest, Nadig said, noting that ETFs’ inflows have surpassed mutual funds’ for years.

Nadig noted significant interest in ETFs, including innovator funds and others, that use options to allow investors to limit downside. Options collar strategies have pulled in $7 billion year to date, he said.

While the launches of single-stock ETFs are gaining significant attention, they’re not for the average retail investor and have attracted only $80 million combined, according to Nadig. There eventually could be thousands more single-stock ETFs, with the potential for multiple funds for every stock, he said.

“They’re an interesting expansion of the toolkit for very active traders,” he said. Nadig expressed concern, however, that single-stock ETFs will be used by people who don’t understand them and said they’re not suitable for long-term investors. “They are truly daily trading vehicles.”

Single-stock ETFs use derivatives to generate leveraged or inverse returns on individual stocks,  Morningstar explained recently, strongly urging average investors to avoid these “extremely risky” investments. 

Single-stock ETFs suffer from “the most non-intuitive math in the market,” Vetta Fi’s Nadig said, explaining they may bear little relation to the underlying stock’s actual movement if held for more than a day.

These ETFs use swaps to generate daily exposure, negotiating with a bank for a daily settled swap, he explained. If Tesla shares move down, for example, the inverse swap counterparty moves cash into a custodial settlement account for the Tesla ETF. If Tesla stock rises, the fund moves money into the bank’s account.  

“It’s a bar bet that’s settled every night and put on again in the morning,” he said.

Dinah Wisenberg Brin

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