KNG: Dividend Aristocrat Covered Call ETF (BATS:KNG)

J Studios/DigitalVision via Getty Images Overview Building a diverse dividend portfolio can require a lot of effort and due diligence when it comes to figuring out what companies match your level of risk tolerance. Trying to maintain a diverse exposure to different industries can require a lot of up front capital and research. Thankfully, dividend focused ETFs eliminate a lot of these troubles by delivering instant diversification. FT Cboe Vest S&P 500 Dividend Aristocrats Target Income ETF (BATS:KNG) offers investors this instant diversification while also delivering a superior dividend yield than some alternatives. KNG has a current dividend yield of 8.8% and this is achieved by the use of a covered call strategy. Data by YCharts However, we can see that this focus on dividends does present some downsides. KNG significantly underperforms the S&P 500 (SPY) in both price return and total returns including distributions. It ultimately comes down to what your main investing objective is. Perhaps you are an older investor that is looking to build a stream of reliable dividend income to supplement your retirement. In this scenario, you would likely be okay with this underperformance against the market if the tradeoff meant that you’d now have another stream of income to support your lifestyle expenses. However, if you are a younger investor with many active working years ahead, then KNG may not be the best choice for you, and that’s totally okay. KNG has a very recent inception, dating back to 2018 and has an expense ratio of 0.75%. The fund is managed by First Trust Advisors and maintains exposure to dividend aristocrats. These are companies that have a consistent track record of raising dividends year over year, for at least twenty five consecutive years in a row. This means that KNG tries to focus on well-established companies that have a reliable reputation for valuing the dividends they provide. The general assumption is that if a company was able to consistently raise their dividend for such a long period of time, it must mean that they have consistently increasing cash flows. Therefore, let’s first start by reviewing the fund’s strategies and holdings within. Strategy & Holdings KNG’s portfolio and execution is focused around two different aspects of the fund. Firstly, KNG maintains exposure to a portfolio of stocks that are within the dividend aristocrats index. Like previously mentioned, these are companies that have increased their dividend payouts for at least twenty five years in a row. Secondly, the fund takes this portfolio of holdings and deploys a covered call strategy against its holdings by implementing short call options on each of the stocks within. The covered calls are sold by the fund on the third Friday of every month, with an expiration on the third Friday of the following month. The strike price that’s set is as close as possible to the closing price of the underlying stock at the time the call is written. In short, KNG employs an at-the-money call option strategy and collects the premium for each transaction. While this can boost the income generated, it can cripple the total price return here. The total option overwrite percentage sits around 20% of the net assets of the fund. Taking a look at the most recent fact sheet reveals that the primary sector exposure is within consumer staples, making up a weight of 24.02%. This is closely followed by the industrials and materials sectors, making up 22.67% and 12.24% respectively. The focus on these sectors came as no surprise, as companies that operate in these areas are typically less growth oriented and are known for their consistent and predictable cash flows. For example, consumer staples consist of companies that generally do well despite what economic conditions look like. The same thing applies for industrials, as they provide some essential products and services that are paid for regardless of what economic cycle we are going through. KNG Fact Sheet We can see that the largest holding is C.H. Robinson Worldwide (CHRW) making up 1.92%, which operates as a freight transportation business throughout the US and internationally. This is followed by Walmart (WMT) and Essex Property Trust (ESS), making up 1.76% and 1.73% respectively. Something worth mentioning is that KNG also includes some real estate exposure, which may increase overall volatility and vulnerability to external things such as interest rates. I will circle back to this topic shortly and display how it relates. I ran a quick comparison of these top holdings total return against the SPY, and we can see that they’ve all outperformed since inception. While the past has no indication on future performance, I thought that this serves as a great point of reference to the quality of companies that make up the largest weight of KNG. Data by YCharts So this begs the question: if the top holdings have outperformed the S&P 500, how come KNG underperforms the S&P? Well, this brings me to one of the major downsides of the fund: the inclusion of an option writing strategy. While it can significantly boost the yield that KNG can pay shareholders, it effectively limits the price upside. Downsides The main downside here with KNG is that you are actively exchanging total return for a higher current income. KNG will not be able to capture most of the upside price appreciation of bull markets because of the at-the-money call options that are used here. An at-the-money approach means that the strike price of the call option sits close to the current price of the underlying assets. This concept means that the upside is capped to strike price itself. As an example, let’s imagine that an underlying stock had a strike price at $100 per share. If the underlying stock price rose up to $115 per share, the call option would be executed at the $100 per share strike price. As a result, KNG would not capture any of the price gains above that $100 per share strike price. This is exactly why KNG’s price has remained mostly flat for the year while the S&P has increased over 14%. Even if strong bull markets, KNG’s strategy does not allow it to partake in these upward price movements. Therefore, if you are looking to grow you portfolio value through capital appreciation, you would be better off elsewhere. Data by YCharts An additional downside would be the sector focus. While the fund makeup leans more towards sectors that are a bit more cyclical resistant, these sectors are still a bit more reactive to interest rate changes. For example, the real estate sector (XLRE) was the most impacted by interest rate increases. The sector is heavily reliant on debt financing to fund operational growth through different acquisitions, projects and new developments, or research and development. When interest rates rise, this makes the cost of acquiring new debt more expensive to hold on the balance sheet. Therefore, an environment of higher interest rates slows growth. A similar vulnerability plays out for the consumer sector (XLP) as well. While perhaps less vulnerable to interest rates, the sector is vulnerable to shifts in consumer spending. We saw record high inflation rates throughout 2022 and 2023 and this caused consumers to slow down on their spending. We can see that the inflation level reached as high as 9.1% in 2023. In an environment of higher interest rates, consumers look for ways to save money at any means necessary. This leaves a lot of companies in the consumer staples sector struggling to show any sort of meaningful growth in earnings. Inflation Calculator Overall, we can see the price relationship that KNG has with the federal funds rate. When rates were cut to near zero levels throughout 2020 and 2021, the price of KNG quickly moved to the upside! Lower interest rates fueled the growth of sectors as financing was affordable. Conversely, when interest rates started to get hiked throughout 2022 and 2023, we saw KNG’s price momentum lose its team and stay mostly flat over the next year. Data by YCharts Dividend Something that makes KNG an attractive pick for income investors is that the fund issues its distributions out on a monthly basis. As of the most recently declared monthly dividend of $0.3757 per share, the current dividend yield sits at 8.8%. Despite the high yield, KNG has done an excellent job at raising the distributions over time. KNG has provided 3 years of consecutive dividend growth. The dividend only recently switched over to a monthly frequency, as we can see from the dividend history chart below. Seeking Alpha Additionally, the dividend has increased at a very rapid rate. For instance, the dividend has increased at a CAGR (compound annual growth rate) of 33.74% over the last five year period. This sort of growth makes it easier to enable some fast compounding of your dividend income. To display this, I ran a back test of an initial $10,000 investment at the beginning of 2019. This assumption also includes monthly contributions of $500 per month, as well as dividends being reinvested back into KNG. In year 1 of your investment, you would have pulled in $655 for the year. Fast forwarding to the full year of 2023, you would now be pulling in $3,084. So in a short four-year period you would have been able to quadruple your dividend income through continued investment. Portfolio Visualizer However, the inclusion of an option strategy and exposure to the real estate sector means that the dividends received from KNG are likely comprised of ordinary dividends. Ordinary dividends typically have less favorable tax treatment when compared to the qualified dividends that you’d get from a more traditional dividend focused ETF. Therefore, KNG may be best utilized within a tax advantaged account to offset the potential tax burden. Outlook Since KNG is a bit vulnerable to interest rates and inflation levels, I wanted to provide some insights related to these things. The Fed has consistently left interest rates unchanged over the course of the year as they awaited more economic data to roll in. However, I believe that we may be seeing a shift happen that could incentivize interest rate cuts, would I believe would be favorable for KNG. Inflation levels have consistently trended downward over the last few months, now sitting at the 3% level. Additionally, the unemployment rate has steadily ticked upward and now sits at the 4.1% rate as of June. Lastly, the US Presidential elections are upcoming this year and this may create a market environment of heightened volatility and uncertainty. As a result, I believe that the combination of these factors may be enough data to incentivize the Fed to begin cutting interest rates. Looking back over the last 40 year period of elections reveals that the Fed has more commonly made changes to the federal funds rate. Data compiled by JPMorgan shows us that 2012 was the only time over the last 40 years where rates were left unchanged. While this doesn’t guarantee that rates will be cut this year, it certainly does give us a bit of context on the possibility of it. JPMorgan Additionally, if inflation levels continue to trend downward, consumers may see some relief, and we can see those spending levels start to increase again. This would be positive for KNG since most of their portfolio is exposed to the consumer staples sector. Therefore, I believe that the future is positive for KNG. Takeaway In conclusion, KNG is a great option for investors looking to maintain a diverse exposure to dividend aristocrats while still capturing a higher starting yield. The high dividend yield is supported by the covered call nature of the ETF. While this strategy does have the downside of upside price potential, this may not affect investors that are primarily interested in obtaining a source of high-yielding income. However, if you are looking for capital appreciation, KNG would probably not be a good fit. I think it ultimately depends on what your objective is. KNG’s holdings are vulnerable to different macro environment things such as inflation, interest rates, and consumer spending. However, the high income received may help offset the impact of these things. The strong dividend growth provides the ability to quickly compound dividend income.

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