HIPS ETF: It’s hard to make a good recipe with bad ingredients (NYSEARCA: HIPS)

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This series of ETF reviews aims to evaluate products based on the relative past performance of their strategies and the quality of their current portfolios. As holdings and their weightings change over time, updated advisories are posted as needed.

HIPS facts and portfolio

The GraniteShares HIPS US High Income ETF (NYSEARCA: HIPS) tracks the TFMS HIPS index since 2015-01-06. It has 60 securities, a monthly distribution with a 12-month return of 9.88% and a management fee of 0.70%. However, it is a fund of funds and the total expense ratio is 2.88%. This is a first red flag.

As described by GraniteShares in the prospectus, The rules-based index measures the performance of up to 60 U.S.-listed high-income securities that typically have “pass-through” structures that require them to distribute substantially all of their earnings to shareholders under form of cash distributions. This “high income, pass-through” strategy is known as HIPS.

Eligible securities must meet market capitalization and liquidity thresholds. The index then selects up to 15 stocks for each of four pass-through categories (REIT, MLP, closed-end fund, asset management/BDC) based on a score that includes performance (highest is better) and volatility (lower is better). The constituents are equally weighted in each category. Category weightings are adjusted to minimize volatility and maximize return, measured over a look-back period. A minimum category weighting is set at 15% and a maximum MLP weighting at 25%. The Index is replenished annually and may be rebalanced quarterly under certain conditions.

HIPS currently holds 51.7% of asset value in closed-end funds, 19.2% in MLPs, 15.3% in BDCs and 13.7% in REITs (primarily mortgage REITs). The fund is fairly concentrated: the top 15 holdings, listed below, account for 51.6% of asset value.

Teleprinter

Last name

lester

CTF

First Trust Senior Floating Ra

3.91%

FINS

Angel Oak Financial Strategies

3.76%

JQC

Nuveen Credit Strategies Incom

3.76%

ARDC

Ares Dynamic Credit Allocation

3.53%

not a word

DoubleLine Yield Opportunities

3.53%

HYI

Western Asset High Yield Definition

3.52%

BGH

Barings Global Short Duration

3.45%

CIO

PGIM High Yield Bond Fund Inc.

3.43%

JRI

Nuveen Real Asset Income and G

3.42%

GHY

PGIM Global High Yield Fund Inc.

3.33%

EAD

Allspring Income Opportunities

3.33%

KIO

KKR Income Opportunities Fund

3.31%

HYT

BlackRock Corporate High Yield

3.27%

HIX

Western Asset High Income Fund

3.07%

EMD

Western Asset Emerging Markets Debt Fund Inc.

2.97%

Historical performance

The following table compares the performance of the HIPS since inception with the S&P 500 and a more relevant benchmark: an equally weighted portfolio of 4 ETFs representing the 4 HIPS asset classes, rebalanced annually. For this calculation, I chose Amplify High Income ETF (YYY), iShares Mortgage Real Estate ETF (REM), VanEck Vectors BDC Income ETF (BIZD) and ALPS Alerian MLP ETF (AMLP). Distributions are included and reinvested. In doing so, I have narrowed the universe of REITs to mortgage REITs. This may not be entirely correct, but since yield is a primary selection factor, the REITs selected are primarily of the mortgage type.

since 01/13/2015

Full return

Annual return

Sampling

Sharpe report

Volatility

HIPS

7.48%

0.94%

-54.04%

0.11

22.45%

AAAA+REM+BIZD+AMLP

19.17%

2.30%

-56.31%

0.19

23.80%

TO SPY

106.96%

9.88%

-32.05%

0.63

15.62%

HIPS lagged the equity benchmark by far, and it also trailed the ETF mix by 1.36 percentage points in annualized return. This means that the strategy failed to add value compared to the combination of passive indices. This is a second red flag.

The following graph compares HIPS with the 4 ETFs individually:

HIPS versus YYY, REM, BIZD, AMLP

HIPS versus YYY, REM, BIZD, AMLP (Portfolio123)

In fact, HIPS shows a 40% capital decay since its inception at the time of writing:

HIPS share price

HIPS share price (Google Finance)

Be that as it may, the 4 ETFs corresponding to the 4 “pass-through” categories have lost value during the stock exchange since their respective creations (see following graphs).

Stock price YYY

Stock price YYY (Google Finance)

REM share price

REM share price (Google Finance)

BIZD share price

BIZD share price (Google Finance)

AMLP share price

AMLP share price (Google Finance)

The problem is structural, not related to management: it is almost impossible to make a good recipe with bad ingredients. Other similar ETFs like the Global X Alternative Income ETF (ALTY), reviewed here, have the same issues.

This problem is not specific to HIPS and ALTY: securities with yields above 6% suffer from capital deterioration. The 10-year average annualized return, including dividends, of all ETFs with a daily volume greater than $100,000 and a return greater than 6% is 2.3%, for an average return of 8.8% ( data calculated with Portfolio123).

The decrease in capital also means the decrease in the flow of income. HIPS has maintained a consistent monthly distribution for some time, but I doubt it will be sustainable. Yield cannot increase indefinitely to compensate for the loss in asset value.

The full picture for an income-seeking investor is not a pretty one, given the current rate of inflation and the tax paid on distributions. HIPS could be used as a swing trading or tactical allocation instrument, but I don’t see it as a reasonable buy and hold investment. This is true for a number of high yield instruments, not just this one.

A solution to obtain high yields without rotting

Capital and income degradation is a structural problem in many closed-end funds, as in most high-yield instruments. However, it is not inexorable if one knows how to trade CEFs instead of using them as buy-and-hold instruments. I designed a 5-factor ranking system statistically linked to futures returns across the entire CEF universe, and began publishing the top 8 ranked liquid CEFs in Quantitative Risk & Value (QRV) after the March 2020 market crash. The list is updated weekly. Its average dividend yield varies around 7-8%. This is not a model portfolio: trading the list every week is too expensive in terms of spreads and slippage. Its purpose is to help income investors find funds with a good entry point. In the table and graph below, I give the hypothetical example of starting a portfolio on 03/25/2020 with my initial list of “top 8 ranked CEFs” and updating it every 3 months since then, skipping intermediate updates to limit transaction costs. Return is calculated with initially equal-weighted holdings using closing prices on quarterly rebalancing days, with no trading fees. Dividends are reinvested at the beginning of each 3 month period.

since 03/25/2020

Full return

Annual return

Sampling

Sharpe report

Volatility

The 8 best quarterly CEFs

128.04%

38.57%

-20.21%

1.56

20.30%

TO SPY

54.21%

18.70%

-24.37%

0.82

19.51%

CEF List Best Performers

CEF List Best Performers (graphic: author)

Dates and listings can be checked in the QRV post history (trial is free). Past performance is not a guarantee of future performance. Data calculated with Portfolio123.

The “Best 8” list has been quite volatile in 2022, but far more resilient than the major stock and bond indices. I’m not claiming it will beat SPY in the future like it has for the past 2 years, but a rebate-focused rotation strategy in CEFs has a much better chance of protecting both capital and the flow of income against erosion and inflation than any high-produce passive investments like HIPS.