What’s Not to Like About a Fund With a 7% Yield

You might impulsively buy a stock that has a 7% dividend yield. Instead, you should soberly ask whether you might lose more money if the stock price falls than you’ll earn on the dividend.

You could withdraw $700 from a $10,000 savings-account balance earning only 0.06%. You’d be foolish, however, to call that a 7% “yield,” because you didn’t earn it from interest income, and now you have only $9,300 in savings left.

You should be just as tough-minded toward Wall Street’s ideas for earning higher yields.

Consider the Strategy Shares Nasdaq 7HANDL Index, an exchange-traded fund. Since its launch early in 2018, the fund has provided steady monthly payouts that have averaged 7% annually.

“It’s a little recycling cash machine,” says Jonathan Rothschild, an individual investor in the New York area who owns shares of the 7HANDL fund. He isn’t the only one who likes it. The ETF has attracted $1.2 billion in 2021, according to FactSet, growing to $1.4 billion in total assets.

But the 7HANDL fund, which owns both stocks and bonds, has made trade-offs to achieve that high yield.

The ETF’s distributions are amplified with leverage, a form of borrowing. And those 7% annual payouts are generated only partly from safe bonds, but largely from gains on systematically trading riskier stocks.

So capital appreciation isn’t always plowed back into the portfolio, where it could augment total return by growing over time at potentially higher rates. Instead, it’s converted into current yield and paid out to investors.

The idea is to use modest amounts of leverage and lots of diversification to generate high income at moderate risk, say David Cohen and Matthew Patterson, co-founders of HANDLS Indexes, the firm that designed the strategy on which the 7HANDL fund is based.

The fund’s holdings consist of 19 ETFs that, together, own an eclectic collection of bonds and stocks.

Over the past 12 months, the underlying ETFs generated 2.96% in income, says Mr. Patterson. So how did that turn into a 7% yield?

Some of the difference comes from the leverage, which adds both return and risk. It also comes from stocks. Invesco QQQ Trust, which tracks the returns of the Nasdaq-100 index, is one of 7HANDL’s top holdings at nearly 7% of total assets. It’s up 24% this year. Global X MLP ETF, which holds energy partnerships, is another big position at 6% of assets. It has gained 34% in 2021.

A booming stock market isn’t what most conservative investors think of as a source of income. And for good reason: When stocks stop going up, a fund like this can lose a main source of yield.

“If you’re getting a total return of less than 7%,” says David Miller, the ETF’s lead portfolio manager, “the net asset value would certainly decline in that scenario.”

That’s already happened. Between Feb. 19 and March 23, 2020, when the S&P 500 lost 34%, 7HANDL fell by 20%. In late 2018, when U.S. stocks lost just under 20%, the fund dropped 9%.

In a protracted bear market, 7HANDL would probably have to eat into its own assets to sustain its monthly payouts at that 7% annual rate. You’d still get high yield—and, most likely, a negative total return. (Of course, most stock funds would decline even more.) Earlier versions of so-called “managed-distribution” funds have tended to shrivel in value over time.

Special tax features of ETFs have enabled 7HANDL to distribute stock gains as monthly yield without creating an immediate tax burden for its shareholders.

Giving investors their own money back like that is called return of capital, and 7HANDL is already doing it—although, so far, its principal value has continued to grow.

The aggregate U.S. bond market has lost about 1.5% in 2021. With nearly half its assets in bonds, 7HANDL has gotten much of its 7% distribution by harvesting gains on its stock funds. Nearly 75% of its monthly payouts this year, on average, have been return of capital.

Receiving a portion of your distribution as return of capital means that part of 7HANDL’s payout isn’t currently taxable. However, “each time you get a return of capital, you’re having to reduce your basis,” says Melissa Labant, a tax principal at CLA LLP, an accounting and professional-services firm in Arlington, Va.

That means your investment’s cost for tax purposes goes down—and the amount of appreciation subject to future tax goes up.

Of course, it’s usually better to pay taxes later than pay them now—but that might not necessarily hold for certain investors or if capital-gains rates rise in the future, says Ms. Labant.

So, yes, you can get a 7% yield in a 2% world. But at some point the check might come for that free lunch.

Write to Jason Zweig at intelligentinvestor@wsj.com