Navigating Volatility: The Sustainable Yield and Risk Mitigation Strategy of MDST ETF

The energy sector has long been a rollercoaster for investors, with prices swinging wildly due to geopolitical tensions, supply disruptions, and shifting demand. Amid this turbulence, the Westwood Salient Enhanced Midstream Income ETF (MDST) positions itself as a steady hand, offering income-focused investors exposure to midstream energy infrastructure while employing tactics to soften market shocks. Let's dissect its sustainable yield potential and risk mitigation strategies, and determine whether it's a worthy addition to portfolios in today's volatile landscape.

The Midstream Advantage: Stability in a Chaotic Sector

Midstream energy companies—those involved in the transportation, storage, and distribution of oil, gas, and refined products—are inherently less volatile than upstream producers or explorers. Their business models are asset-heavy, with long-term contracts and regulated pricing structures, providing a relatively predictable cash flow. MDST's portfolio, concentrated in top-tier midstream players like Energy Transfer (ET), Enbridge (ENB), and Williams Companies (WMB), leverages this stability.

The ETF's top 10 holdings, accounting for ~64% of its portfolio, include names with decades of operational history and strong balance sheets. This concentrated, value-oriented approach (its style leans mid-value) aims to capture dividend-rich assets while avoiding the speculative risks of smaller or growth-oriented energy plays.

The Covered-Call Overlay: Boosting Income, Taming Volatility

MDST's key differentiator is its covered-call strategy, which involves selling 1-month call options 4-5% out-of-the-money (OTM) on its holdings every month. This generates premium income that supplements dividends, contributing to its 10.2% annualized distribution rate. However, this rate is currently 100% return of capital (ROC), meaning investors are receiving a portion of their principal back—a red flag if sustained.

The strategy also aims to reduce downside risk. By capping upside potential (if underlying stocks rise above the strike price), it creates a “buffer” against price declines. Historical data suggests this approach has helped MDST outperform midstream benchmarks like the Alerian Midstream Energy ETF (AMZ) during downturns. For example, in 2023's energy selloff, MDST's NAV fell by 8%, while AMZ dropped 15%.

Sustainable Yield: A Glass Half-Full or Half-Empty?

The ETF's SEC Yield of 3.69% (as of May 2025) is far below its distribution rate, signaling a dependency on ROC to maintain payouts. While this can boost short-term returns, prolonged ROC distributions erode NAV, a critical metric for ETF health. MDST's NAV has already dipped slightly since its 2024 launch, though its 22.95% NAV return year-to-date still outpaces many peers.

Investors must ask: Can MDST sustain its distribution rate? The answer hinges on two factors:
1. Base Income Growth: The ETF's midstream holdings must generate higher dividends or capital gains to offset ROC. While midstream dividends are stable, they're unlikely to surge in a low-growth energy environment.
2. Options Premium Consistency: The covered-call strategy's success depends on volatility levels and market direction. If energy stocks rally sharply, MDST misses out on gains but gains premiums. However, in stagnant or falling markets, premiums provide a lifeline.

Risk Factors: The Devil in the Details

• Commodity Price Sensitivity: Midstream firms still rely on energy demand. A prolonged downturn in oil/gas prices could strain their cash flows.
• Regulatory Risks: Pipeline projects face permitting hurdles and environmental scrutiny, which could delay revenue streams.
• Concentration Risk: With ~64% of assets in its top 10 holdings, MDST's performance is highly tied to these names' health.

The non-diversified structure and 0.80% expense ratio are minor drawbacks, but the ETF's avoidance of K-1 tax forms (via equity-only holdings) simplifies tax reporting compared to MLP alternatives.

Investment Thesis: A Place for MDST in Portfolios?

MDST is not a pure income play—its ROC-heavy distributions require investors to accept NAV erosion unless base income improves. However, it offers three key advantages:
1. Predictable Cash Flow: Midstream's regulated, fee-based model reduces revenue volatility.
2. Volatility Mitigation: The covered-call strategy provides downside protection in turbulent markets.
3. Tax Efficiency: No K-1 forms make it easier to hold in IRAs or taxable accounts.

For income-focused investors with a 3–5 year horizon, MDST could be a niche holding, but allocations should remain small (e.g., 5–10% of an energy allocation). Pair it with broader energy ETFs like XLE for diversification.

Final Verdict: Proceed with Caution

MDST's blend of midstream stability and options-driven income is compelling, but its ROC-heavy distributions demand scrutiny. Investors should monitor its SEC Yield trends and distribution sustainability. If base income grows or the covered-call strategy generates consistent premiums, this ETF could outperform over cycles. For now, it's a high-reward, high-risk tool best suited for those willing to trade yield for some NAV volatility.

In a sector where patience is rewarded, MDST offers a unique angle—but investors must be ready to navigate its trade-offs.