When people start investing for an income stream, as I advocate, quite a few get drawn towards finding the highest yielding investments.
After all, if you want income, then a high yield is better, right?
Well, no not necessarily. There’s lots more to it than that, which we’ll cover in this post.
High yield funds, stock picking, yield vs growth, and individual goals – we’re doing a round-the-world trip! Then we’ll put it into the context of Financial Independence and finish with some simple take-home principles and a core message. Let’s go!
Yield vs Growth
Before we begin, I dived into this topic before and set the record straight on dividend-focused investing in a post titled “Should You Invest for Income or Growth?” It goes hand in hand with today’s article, so definitely check that out.
It should be obvious there are two dimensions to most investments. Yield, being current income. And growth, being the level at which that income (or the investment’s value) increases over time.
Keeping it simple, investments with a high yield, tend to have low expected growth. And investments with a low yield, tend to have higher expected growth.
Wait a minute, why ‘expected’ growth? Well, because nothing is certain. Current yield or income is a bit more certain because it’s based on current profits. But it’s important to note, this is also subject to change!
Let’s take the example of a 7% annual return. Imagine a sliding scale of investment options, each offering different levels of yield and growth. For example…
— Option A has a yield of 7% and 0% growth.
— Option B has a yield of 5% and 2% growth.
— Option C has a yield of 3% and 4% growth.
— Option D has a yield of 0% and 7% growth.
Oversimplifying, as investors we get to choose which option we prefer. That could be based on our desire for income, our tax rate, and our views on each investment, among other things.
Some investors think, “Sweet, I’ll just go for all the highest yield stuff and build my passive income faster!” “Why should I bother with any of the lower yielding options!?”
Why you shouldn’t pack your portfolio with the highest yield stocks
Firstly, some companies trade at a high yield because their share prices have been hammered. Not because of a general market panic, but because the business or its industry faces genuine problems.
That being said, local investors like the tax-effective nature of Aussie dividends, so some tend to fill their portfolio with high yielders. And in Australia, this typically means buying lots of bank shares! But this isn’t a great idea for a few reasons.
Our sharemarket is already relatively top heavy. So even owning an index fund or diversified LIC means holding a decent amount in banks – around 20% or so.
Loading up a portfolio with banks means being very reliant on one industry for dividend income. Yes, they’ve done well historically, but they’re now facing some challenges (more on this later). The point is, by doing this we’re taking extra risk. So that high income comes at a cost.
A portfolio of only high yield stocks might have poor growth over time. This means dividends may struggle to increase, which is far from ideal. Dividends may even fall in the short term, if the high yield proves unsustainable.
Certainty of income?
Maybe a short term hit to your dividends doesn’t sound so bad, as long as the long term works out okay?
People are often attracted to high yielding stocks for the certainty of having a higher income today. I totally get it. But the irony is, a highly concentrated approach of holding a handful of high yield stocks means reaching your goal is actually less certain, compared to a diversified portfolio.
Some may argue my approach of investing mostly in Australia is kinda the same thing, versus having a global portfolio. I guess the key difference is, I’m not relying on a few companies in one industry for our income.
I’m backing an entire country and economy, with hundreds of companies in various sectors, with many doing business all around the world. So when certain companies or sectors are struggling, plenty of others are doing fine. Besides that, I’m comfortable with this risk and have found a level of diversification that feels right for our situation.
Back to the point. There is more risk and uncertainty picking high yielding stocks to achieve your income goal. And over time you might be missing out on the holy grail of investing – an effortlessly growing income stream which needs zero management from the investor.
Why? Because that’s much more achievable (and likely) with a diversified set-and-forget portfolio, than with a handful of individual companies.
High yield funds
Given the risk of uncertainty of picking a few high yield stocks, some investors then seek out high yield funds instead. On the surface, this makes total sense. It takes away the risk of picking your own stocks, outsources the effort and offers some diversification.
There are simply too many funds to cover. But let’s look at a few I’ve come across that are targeting the ‘high yield’ focused investor.
(The following is simply my personal thoughts on certain funds/products, not a view on the companies or fund providers themselves.)
This is a highly active fund which buys and sells stocks around their dividend dates to collect the highest possible dividends and franking credits throughout the year. This is known as ‘dividend stripping’.
How does the following sound as an income stream?
Holy cow, where do I sign up? This is income investing on steroids, right?
WRONG! While Betashares has some perfectly fine funds, including low cost index options, this is not one of them. In my opinion, this fund is an absolute piece of garbage. I’d almost call it predatory. A while back, I wrote an article about HVST for The Motley Fool, which you can find here.
Safe to say, I’m not a fan!
Total returns have been less than 1% per annum since October 2014. Or almost 4% per annum including franking. That compares to the market’s return of 9.7% per annum, before franking, according to this interactive Vanguard return chart.
Shares (units) listed at around $25 each. Today they’re trading at around $15. A 40% loss of value.
How about the income stream? Well, the first few monthly distributions were around 22-23 cents each. The last two payments were around 10 cents each. That’s a decline in income of over 50%. The exact opposite of what we want! Great income, huh?
Why does this happen? Because the 10-15% yearly income stream is simply not possible, since that is larger than what long term total returns would be.
The solution? You’re supposed to reinvest the income and franking, then somehow create your own income stream. With total returns of 0-4% per year, good luck with that! Oh, and the fee for this marvellous service is almost 1% per annum. PASS!
I can imagine many income-hungry retirees being lured into funds with the appearance of an ultra-high yield. Only to later learn (the hard way) that it’s too good to be true and see both their income and capital decline. And frankly, that gives me the shits.
By the way, I’m not picking on Betashares – again, they have some good funds too! I’m just running through some high yield funds which have been pointed out to me.
OK. YMAX holds the biggest 20 names in the ASX. Banks, miners, etc. And it boosts the fund’s yield by selling options against these holdings. This effectively trades capital growth for extra income.
In my view, this is a bit more harmless than the ‘dividend stripping’ strategy. But this portfolio is still very concentrated, with only 20 companies held overall. YMAX has about 50% exposure to financials, compared to 30% for the ASX300.
YMAX currently offers a yield of 9.5%, or 12% including franking. Does that sound realistic to you?
Anyway, the fund listed in November 2012. Here’s the performance since then…
The fund has underperformed the top 20 index (the exact same holdings) by 3.3% per annum. So the options trading has been a huge drag on returns. Fees charged are currently 0.76% p.a.
In the last 5 years, shares have gone from $11, down to around $8.50. A drop in value of more than 20%. Well, how about the income?
Total distributions paid in 2014 was 99 cents per unit. In 2019, total distributions paid was 76 cents per unit. A decline in income of more than 20%. Is that a coincidence? No.
Again, the yield looks great on paper. But in real life, it’s probably not the outcome investors are hoping for. The lesson is, you cannot expect an ongoing yield higher than a realistic annual return! If long term total returns are 8% per annum, then expecting a 9% cash yield is, well, wishful thinking.
Sorry, but the tooth-fairy isn’t going to fund those dividend payments.
High Yielding LICs
There are also a large number of listed investment companies with high yields. But this high yield doesn’t come from the dividends paid by the underlying portfolio. Instead, the high yield is generated by trading.
Typically, these funds do lots of buying and selling, and hold stocks for a relatively short time. Capital gains are harvested by taking profits on their winners and distributing money to shareholders as fully franked dividends.
This doesn’t sound like a big deal, and in isolation, it isn’t. But when a fund is paying out very large dividends sourced from capital gains, there is a real risk the LIC runs out of profits to pay out. A bad run in the markets, or with their strategy, will see the dividend become unsustainable and eventually cut – perhaps drastically.
The company structure helps these LICs smooth out dividend payments over time. But it’s not magic. A strategy reliant on harvesting capital gains to pay large dividends is far riskier than one based on simply collecting the natural dividends from the underlying companies.
Therefore, as individuals, our investment income is on far less stable footing with these funds than more passive options.
This fund is closer to the buy-and-hold investing that we preach around here. And it was actually the first share I ever invested in.
VHY aims to provide ‘low-cost exposure to companies listed on the Australian Securities Exchange (ASX) that have higher forecast dividends relative to other ASX-listed companies’.
At the time of writing, the yield on this fund is a more realistic 5.3%, or 7.3% including franking. As far as high yield funds go, this is a decent option. Low cost (0.25%), not promising the world, and no fancy trading of options. It also holds 60 stocks right now, which is much more than when I held it (about 40) and is better than the other options in this space.
The issues for me are, it still has over 40% in financials. It holds stocks based on ‘forecast dividends’, meaning the portfolio is changed around a fair bit (turnover is regularly between 20% and 40%). This causes the fund to be less tax-efficient (more selling) and the income to be less reliable (capital gains paid out) than a buy-hold portfolio.
These aren’t big issues. But personally, I decided to move towards other income-focused funds like the old LICs, where the focus is long term ownership of companies, more diversification and steadily growing income.
This fund simply aims to hold and replicate the returns from the top 20 companies on the ASX. Nothing else. Like the YMAX fund, without the options trading. Fees are currently 0.24% p.a.
ILC is a concentrated portfolio of large caps. It’s good in the sense that it’s easy to understand and you know what you’re getting.
The current yield is 5.4%, before franking. Performance has been in line with the top 20 index, as you’d expect. My only concern here is the concentration. Financials currently represent almost 47% of the fund.
I mean, sure, you’re getting a higher yield than a standard Aussie index fund or LIC, which typically yields around 4%, plus franking. But it’s not much more. Is it really worth it?
The Yield/Diversification trade-off
It should be obvious by now that there is a clear trade-off going on. To achieve a higher yield, all else being equal, requires taking on some extra risk.
The above funds are very heavy in financial stocks. If bank dividends drop, a crunch in income is inescapable. Interestingly, 3 out of the 4 big banks have now cut their dividends in the last couple of years.
Of course, there are other sectors like mining. But mining profits are notoriously volatile, and just a few short years ago, BHP cut its dividend by 75%! So that’s hardly a safe haven either.
So far we’ve covered why direct high yield stocks like banks don’t seem to be a great idea. A top 20 fund would be a small improvement. And a high yield fund like VHY is better again.
The next step up is widely diversified low cost LICs and finally, broad market index funds. These two are clearly the most desirable choice in my eyes.
See a pattern here? Each step brings a slightly lower yield, but much improved diversification and a more reliable outcome. This means a higher likelihood of delivering a sustainable, and growing income over time to meet an investor’s cashflow needs.
This way, the performance of the underlying companies averages out. So even though some won’t do well, others will, and this is what drives income growth over time.
The importance of dividend growth
Widely diversified funds like low cost LICs, and to a greater extent index funds, hold a large basket of companies (100 to 300). Each company inside has earnings which are growing (or declining) at a different pace.
So within reason, it doesn’t matter what’s happening to the banks, or to the mining giants, or any company in particular. Yes, those companies matter because they’re large, but the results of the whole basket is more important.
“While the banks and some of the larger ‘blue chip’ companies pay good dividends, few of them have been able to grow them consistently over this period and indeed, a number have cut their dividends in recent times. For Argo to achieve its own dividend growth, we have had to derive a growing yield from other investments. When we look at our portfolio over this seven-year period, there are 21 companies that have increased dividends in each of those years, including 14 which have increased by more than 5% per annum.”
“While we have added and trimmed some of the positions over this time, this group of companies have been the prime contributors to Argo’s continued dividend growth. Importantly, approximately 25% of our portfolio is held in these 21 companies and this has allowed us to continue to grow our dividend, despite dividend cuts from other companies.”
Those annual dividend growth rates show why having a larger, more diverse portfolio makes sense. So you can benefit from companies with faster growing earnings and dividends, alongside those that simply pay a nice income today.
By the way, Argo also had this to say about the banks…
“The banks face a number of other challenges to their outlooks including:
• Lower interest rates impacting on net interest margins
• Slower credit growth due to tighter lending standards and increased competition from new
• Customers’ increased ability to switch financial institutions through new open banking regimes
• Higher capital needs to meet APRA’s ‘unquestionably strong’ capital requirements
• Increased spending on technology to stay competitive, although this will cut some ongoing
Putting it in context
Some investors, like older retirees, might prefer a higher yield regardless of growth. They accept the higher risk and simply want the higher income now to pay for living expenses. I understand that, especially when franking credit refunds are included!
But for most of us with very long time horizons, growth is essential for our portfolio.
Of course, you can definitely make high yield investments a small part of your portfolio if you like them or they interest you. That’s what I’ve done. And provided the yield seems sustainable. But obviously some judgement is required here.
Our high yield choices are a few real estate investment trusts (REITs) and peer-to-peer lending. Simple rent-collecting REITs are typically more predictable and easier to understand than individual companies, but there is still extra risk involved (an article on REITs is coming, I swear!).
Now, it’s totally possible you find solid high-yielding companies that simply are unloved by the market. But I wouldn’t bet on that happening too often. Like that grey-looking meat at the supermarket, things are often discounted for a reason!
So be careful of the yield trap. If you’re not sure whether a yield is sustainable or not, or you can’t figure out why it’s so high… then it’s probably best to avoid.
So what’s the core message?
Some of this stuff depends on each investor’s goals, tax rate, and their personal need for income right now.
But my point is, don’t blindly chase yield because you think it’s easy income, or it means you’ll get a higher return. As I’ve said before, growth is important and is a crucial part of any sensible income-focused investment strategy.
We don’t need huge growth, but we do need it. While a high-ish sustainable yield is fine, increasing cashflow over time is the goal.
I love income. But I’ll be sticking firmly with low cost options that are easy to understand and widely diversified. Things like index funds and old LICs for the majority of our savings.
Besides, look around the world today. Markets are up and yields are low almost everywhere. Interest rates are close to zero, so cash is earning next to nothing. All things considered, a 4% dividend, plus franking credits, is a damn good yield!
If you’re building a portfolio for Financial Independence and are frustrated with your progress and passive income so far, here’s what to do…
Save more money and buy more shares! That’s a simple and guaranteed way to see your investment income increase!
Oh, and maybe try to practice the Art of Patience.
It’s tempting to look for the highest yield stocks or funds to increase your income in the short term – I totally get it. But it’s rarely a good idea.
Instead, build a simpler and more diversified portfolio which provides a healthy balance of income and growth. Yes, that may mean a lower yield today. But it’s a much safer and reliable way to ensure you end up with ever-larger sums deposited into your bank account to fund your early retirement.
And that’s the true happy ending I want for you. Your very own Financial Independence utopia!
What are your thoughts on this topic? Do you have any high yield investments in your portfolio? Let me know in the comments…