Inventing new products to solve difficult financial problems has been a mainstay of the mutual fund industry. In the 1990s, the fund industry introduced target-date retirement funds. That was followed by the launch of target-maturity bond funds that customize a person’s fixed-income exposure to a defined year.

By extension, the exchange-traded fund industry has done plenty of innovating itself. And the latest twist could someday rival the popularity of previous inventions: targeted distribution funds.  

Sometimes referred to as “managed payout funds,” targeted distribution funds aim to deliver lifetime income payments via a minimum distribution amount. Certain funds offer a specified monthly payout while others deliver variable payments based upon fund performance. Let’s examine ETFs that follow this strategy.

Aiming For A 7% Distribution

Launched in January 2018, the Strategy Shares Nasdaq 7HANDL Index ETF (HNDL) bills itself as the first ETF designed to produce a targeted distribution. According to fund literature, HNDL’s goal is an annual 7% distribution rate. Distributions occur monthly and some of the payouts will be a mix of dividends, capital gains and a return of investor’s principal.

HNDL’s underlying index is split evenly between a core portfolio and another portfolio called the Dorsey Wright Explore Portfolio. Both portfolios use ETFs as their main investment vehicles.

The core portfolio has a 70% allocation to U.S. aggregate bond ETFs while 30% is allocated to U.S. large-cap stock ETFs. The Dorsey Wright portfolio is spread across ETFs covering various asset classes but it leans toward high-income generating categories. HNDL juices its distribution by adding leverage in the amount of 23% of the overall portfolio. The fund charges net annual expenses of 0.95%.

Shooting For 5%

Like HNDL, the Global X TargetIncome 5 ETF (TFIV) targets a fixed distribution payout. But it does so less aggressively by shooting for an annualized yield of 5%, net of fees.

The bulk of TFIV’s underlying investments are committed to preferred securities (20.1%), high-yield bonds (19.9%) and senior loans (19.5%). To obtain its market exposure to these areas, the fund uses ETFs, some of which include Global X’s own funds including the Global X U.S. Preferred ETF (PFFD) and the Global X SuperDividend ETF (SDIV).

A close cousin of TFIV is the Global X TargetIncome Plus 2 ETF (TFLT), which targets a 2% annual distribution rate. Neither of the Global X targeted distribution funds use leverage.

Sizing Up The Market

As fewer workers receive coverage from traditional pension plans, it’s putting pressure on retirement savers to find alternative income solutions after they stop working. Just 16% of all private-sector workers have access to a pension plan compared to 86% of state and local government employees, according to the Bureau of Labor Statistics' National Compensation Survey of 2019. That means the responsibility for replacing lost pension income will fall on the shoulders of retirees. As such, any investment vehicle with annuity-like features could find a willing audience.

And the potential audience for targeted distribution funds is big. There are almost 80 million baby boomers, and approximately 10,000 people are retiring every single day. It's no exaggeration to say that income replacement for retirees is a big concern.

Looking Ahead

How will targeted distribution funds perform during the next bear market? Will they hit their income distribution targets or will they fail? Because these ETFs are so new (all three funds profiled here launched in 2018), it’s too early to know.

But if targeted distribution funds can provide a stable source of retirement income in rocky times, this new class of ETFs could follow the path of other successful targeted retirement date and bond maturity solutions within the fund industry. Time will tell.

Ron DeLegge is founder and chief portfolio strategist at ETFguide, and is the author of “Habits Of The Investing Greats.”