The problem with investing passively for income

By AMP Capital

If you “push your dividend yield too hard” you could end up with an outcome that’s the exact opposite of what you were trying to achieve in the first place, says Tom Young, AMP Capital’s Income Generator Fund Co-Portfolio Manager.

By ‘pushing your dividend yield too hard’, Young means investing in individual stocks and strategies that are optically the highest dividend earners in the market.

“On average, stocks with the highest expected dividend yield end up cutting their dividend over the following 12 months leading to, at times, significant capital loss,” Young points out.

Investors who are investing passively for high income earners will end up being exposed to stocks and strategies in this segment of the market and could be at risk, Young says.

“If you push your dividend yield too hard, you end up being over exposed to this segment of the market, hardly ideal if you want stable and predictable income,” Young comments.

The passive yield trap

Because passive income strategies draw on historical data to target the highest income earners in the market, they end up exposing investors to this less desirable segment of the market.

“This is a segment of the market you want to avoid, or at least be highly selective with,” Young notes.

“The problem many passive yield funds face is that in the race for yield, they end up significantly overexposed to this risky bucket of potential dividend cutters.

“You saw this in the last round of significant dividend cuts in early 2016 when all the resource companies cut their dividend.

In early 2016, the Vanguard High Yield Australian Shares ETF had nearly one third of the fund in stocks that cut their dividend. More recently, this particular ETF has had approximately 10 per cent in Telstra, probably the most high profile dividend cutter from 2017, Young points out.

While the theory behind investing in passive funds broadly is to gain broad market exposure and therefore avoid material loss if any one company has a significant drop in share price, the same theory doesn’t work for passive yield funds, which are actually highly concentrated in a fairly narrow part of the market, Young says.

Actively manage your income

“Traditional stock analysis provided by active managers is often necessary in income investing,” Young notes.

Among the tools in an active income funds managers toolset is the dividend rotation tool, which allow managers to increase yield without being overexposed to potential dividend cutters, Young highlights.

Stocks with the outright highest dividend yields end up most likely to not only cut their dividend yields in the following 12 months, but they also exhibit more volatility than other stocks in the market, Young highlights.

Of particular concern is the yield premium you receive now for taking on this higher risk is significantly lower than it has been historically, Young adds.

The series of charts below highlight these points.

On average, stocks in the top 20 per cent of dividend yield, and especially the top 10 per cent, cut their dividend over the following 12 months and underperform the market.

 Source: AMP Capital, FactSet
Source: AMP Capital, FactSet

Stocks within this group also exhibit higher volatility than other stocks in the broader market.

Source: AMP Capital, FactSet
Source: AMP Capital, FactSet

Of particular concern is that the yield premium you receive now for taking on this higher risk is significantly lower than it has been historically.

Source: AMP Capital, FactSet
Source: AMP Capital, FactSet

“The problem with passively investing for high income is that these strategies often get caught in what we call dividend cutters,” Young says.

“The majority of companies that provide a good dividend yield are defensive companies operating in mature but low growth industries, great for providing a stable and predictable income stream in other words,” he says.

“However, as you move into the top echelons of dividend yield the type of company changes,” Young adds.

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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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