First, I’d like to welcome you to the inaugural edition of the ETF Insights newsletter. I truly appreciate your willingness to commit to a platform like this during periods of economic uncertainty and rising costs of living.
Joining us shows that you’re looking to take your investments seriously and set yourself on the path to financial independence.
I’ll leave this introduction short and sweet to get into some rock-solid content for our first issue.
This newsletter will provide education, market commentary, case studies, and investment strategies built on rock-solid foundations backed by historical data and correct investing fundamentals.
There is a lot, I repeat, a lot of insufficient information out there today.
Whether it be passive income investors preaching incorrect assumptions on high-yielding funds, dividend investors failing to properly assess the impacts of sacrificing a relatively simple (and often higher returning) total return strategy for income, or just influencers being outright financially compensated for promoting a particular fund or fund manager.
I am a firm believer in educating investors the right way, using factual data. From there, people can make their own decisions that best suit their style.
We all have our biases; I have them myself.
However, these biases have been developed based on my investing style and end goals. If I express these biases to investors without also relaying the unbiased information about the markets and investing, then I would be doing people a disservice.
Instead, I prefer to lay out the objective information, and from there, you can make your own decisions, something we’re all capable of doing. That is what you can expect from this monthly issue, and our history of delivering this objective information is why we’ve slowly become one of the go-to resources in the country.
With that said, let’s dig right into the first-ever issue of ETF Insights.
This month’s discussion will primarily revolve around the perceived attractiveness of high-yield ETFs and the fact that, if we utilize historical data and how the markets function, we can see that most of these funds are not optimal for the vast majority of investors.
The misconceptions behind investing for income
Let’s get one thing out of the way before I begin. An income-based strategy for those who are not necessarily looking to accumulate assets but rather utilize cash flows to fuel retirement is one that I can get behind.
However, many investors who own these funds hold them with incorrect knowledge of how the funds and the market overall work or are making suboptimal decisions based on a passive income goal, often referred to in the income investing community as “PADI” or “Projected Annual Dividend Income.”
The fuel to this fire is primarily passive income and dividend income influencers, most of which emerged post-pandemic when retail investing skyrocketed in popularity.
However, hidden behind the large and growing “PADIs” these influencers generate is not some magical investing trick. It’s often just a high rate of savings or a weak-performing portfolio masked by their simple tracking of their growing PADI.
Of course, you’ll never see anyone boasting that the only reason they generate a large amount of income from their portfolios is a $200,000 a year salary and large contributions to their portfolios.
And you’ll certainly never hear them mention they’ve lagged a portfolio of basic index funds to earn this PADI.
They’ll instead say it’s achievable by anyone if they put their mind to it.
This creates an environment in which many investors who would be better off targeting the highest growth possible for their portfolios chase income-producing assets.
I’ve often been criticized for suggesting this, stating that I am telling investors to take on extensive risk to maximize returns.
This just isn’t the case. There is a difference between chasing highly aggressive, speculative investments to catch lightning in a bottle and adopting a total return strategy utilizing high-quality funds, which has been proven to outperform a high-income-based strategy for decades.
Why income? For younger investors, short-term worries cloud long-term judgement
Nobody likes the feeling of a market crash or market volatility in general. We like to see our investments increase in value, and we like to “realize” some of that value.
There is nothing that achieves this feeling better than generating cash flow from a particular investment you own. But there are issues with this.
Too many investors obsess over the short-term. They prioritize structuring their portfolios to generate income over maximizing returns. That income generation, even at the expense of long-term returns, feels good over the short term.
However, our short-term worries of a market crash or market volatility cloud our long-term judgment. Naturally, our fear of loss is much stronger than our desire for gain.
What do I mean by this?
Over the last 100 years, the market has returned 10.6% annualized. I’m not sure about you, but a sample size of 100+ years is enough for me to safely say that if I invest my money in the market today, I’m going to realize positive returns over the long term.
But ultimately, many investors run off the idea that a bird in hand is better than two in the bush.
If the market crashes tomorrow, they’ll still have that income.
Fund managers have no doubt capitalized on this obsession over the last few years as new funds are developed to crank out as much yield as possible. 5-6 years ago, a fund yielding 5-6% may have been considered high income.
Now? It seems like every month we’re seeing new funds yielding 10%-15%, and investors are pouring into them at an astonishing pace.
Distributions and dividends aren’t additional money; they must come from somewhere
When we understand that a dividend, or in the case of an Exchange Traded Fund, a distribution, is simply a return of capital you already own by owning the fund, we start to see that dividends are simply one element of a total return strategy, and in no way provide added returns or added security.
A stock’s price per share is simply its market capitalization divided by the amount of shares available on the market. If a company has a market cap of $1M and has 1 million shares outstanding, the shares will be worth $1 each.
An ETF is much like a stock in terms of how it is valued.
With a fund, the price of the ETF will simply be the net asset value of the fund divided by the number of ETF units available to trade. Net asset value is the amount of money the fund is managing.
If we have an ETF with assets under management of $1M and 1 million units outstanding, the ETF will be valued at $1.
When an ETF pays a distribution, it does so through distributing a portion of its net asset value. In the example above, if the fund paid out $100,000 in distributions, its net asset value must decline by $100,000.
This would ultimately result in a drop in the ETFs price, as it now only has $900,000 of assets under management rather than $1M.
In this situation, you’d now have an ETF worth $0.90 and $0.10 in cash from the distributions received – the exact same amount of money you had prior to the distribution being paid.
Let’s go over a basic example to see how this works…
Let’s assume two investors own an identical fund, 100 shares at $10.
Investor A gets a 5% yield, investor B gets no yield and instead sells 5% of their position at the end of the year.
Investor A owns 100 shares at $9.50 for $950, has $50 cash
Investor B owns 95 shares at $10 for $950 and $50 cash
The result is identical.
However, that cash flow generated by the asset is often viewed as the safer, less volatile form of returns. So naturally, people gravitate towards yield.
Where the danger in high-income funds lies
In the simplest way possible to explain why many high-yielding funds are suboptimal, I’ll say this:
Yield does not equal return
These high-yielding funds need to find a way to earn returns on their assets that match the distribution they pay. This is because as mentioned, fund distributions are not money that comes out of thin air, they’re taken out of the fund’s assets.
If the fund cannot outpace its distribution with returns on its assets, it will deplete assets to continue paying the distribution. As a result, one will hold a fund that pays a high yield but continues to weaken in overall value.
We can look no further than a fund like the Dividend 15 Split Corp fund, trading under the ticker DFN. A flashy 15% yield has led many investors over the years to believe they’d be earning 15% annually.
However, the actual track record of the fund shows it has put up a 4.6% annualized return over the last 10 years, while the S&P 500 has put up 12.74%.
To give you an idea of this performance in dollar figures, $100,000 invested in DFN would have you sitting on $157,691 today.
The S&P 500? You’d be sitting on $331,726 – a difference of $174,035.
This isn’t “chasing growth” via highly speculative or aggressive investments. This is simply buying the most prominent market index on the planet over a high-yielding fund.
Another example that utilizes covered calls
Split Corporation funds are a tricky subject and likely one for a future issue of ETF Insights. But I’d like to go over another example regarding an income-producing strategy that has skyrocketed in popularity post-pandemic: covered calls.
QYLD, an especially popular NASDAQ covered call fund, sports a near 12% yield while giving investors exposure to the high-flying NASDAQ Index.
However, what many investors don’t realize is that the 12% yield has been an illusion practically since the fund’s inception due to high fees, performance drag, and taxes. Investors aren’t earning even close to 12% in terms of total return.
Since its inception in 2014, QYLD has returned 7.6% annually. This means that if you invested $100,000 in the fund in 2014, you’d now have returns of $208,000.
Alternatively, had you simply bought a NASDAQ 100 ETF that doesn’t attempt to generate income, you’d be sitting on $549,222, more than 3.5x your returns from QYLD.
Again, we’re not chasing returns here. We’re not investing in highly speculative growth stocks or going all-in on a particular company to catch huge returns. We’re simply buying an index fund tracking one of the largest indexes on the planet.
Income comes at a cost
There is a popular saying in the investing world, and that is that there is no free lunch in finance.
This means that nothing comes free of cost. If investing was as simple as buying funds that yield 12% to earn 12%, investing would be solved. However, many don’t realize that the cost of high-income generation is often overall returns.
For those in the latter stages of their investing careers, seeking cash flows in retirement to enjoy the decades of hard work they put in to build up their nest egg, the trade-off between income generation and lower returns is one that is generally accepted.
However, for those with a longer time horizon, building a portfolio based on income early, whether through high-yielding funds or stocks, will likely result in that nest egg being smaller by retirement, no doubt leading to regret.
As I highlighted in the few examples I showed today, it can literally cost you years of retirement.
So, what path should you take?
Ultimately, I can’t choose how individuals invest.
The math behind a total return strategy versus a high-income strategy is one that is going to favour the total return strategy in nearly every situation.
However, I do understand that in the real world, math is just math, and there are a lot of external factors at play.
For those who take comfort in generating a high amount of income from their investments, I’m certainly not going to attempt to stop you.
Instead, I hope to highlight the strategy’s downfalls, which are often not discussed by those who advocate for it.
High-yielding ETFs and, even to an extent, high-yielding stocks have a consistent history of underperforming the broader indexes.
One must understand that chasing a high-yield fund strategy will prevent you from taking advantage of the larger returns of a broader-based indexing strategy, one that has been proven to provide rock-solid returns over the long term, backed by more than a century of historical data.
Although older investors may find more benefits in an income-based strategy, and rightfully so, those with a longer investment time horizon should really consider whether generating income from a portfolio when they don’t really need it is worth the lower returns it has historically provided.
