Are these high yield ETFs a trap?

For some income investors, high yield is everything. They want the biggest bang for their buck that they’re going to put into the market. Which, you could say, they’re looking for high current cash flow or high current yield.

To obtain this high current cash flow, they might scan for high yielding stocks or high yield bonds. Maybe even high yielding ETF’s. Searching for high yield is fine, as long as you’re happy with the chance of losing some of your principal off the top, or your principal staying flat over the investments time horizon.

If you would like to know whether some of these ETF’s could be a yield trap, you’ll first need to learn about total returns.

Starting with total returns

Total return is probably one of the most straightforward metrics you can learn, and its merely capital gains plus dividends paid. For example, if you owned a stock and made 6% in capital gains and received a 4% yield, then your total return was 10%. That’s it; it’s as easy as that.

Total Return= Capital gains + Dividends

You need a few numbers to work out the math, but the concept of adding capital gains and dividends should hopefully be easy enough to remember. Once you remember total return and start paying attention to it, you might just come across a few unpleasant surprises.

High yield traps

Many income investors, including me, have been or are attracted to high yielding investments. But there’s usually a reason for an above-average yield. When looking at individual stocks, for example, the high yield usually means the share price is either depressed or collapsed, and the business could be in serious trouble with the dividend most likely on the chopping block.

Some investment vehicles though have good reason to be high yielding (like a REIT, or junk bond) while others are what is known as a yield trap. The high yield is too good to be true, an investor buys the asset thinking they’ll get this phenomenal cash return, and then poof the dividend gets cut, winding up with nothing. In their eyes, once the dividend cut happens, they would feel like they’re holding onto something worthless.

There’s no arbitrary number for what could be considered a high yield trap- usually for me if I start seeing dividend yields of 6% and above I’ll question why it’s high.

High Yielding ETFs

So, what do high yield traps have to do with the total return you ask? Well, there’re a few assets out there that are known as high yielding ETF’s. And, while these do offer high dividend yields and high current cash flow, they also have a dark side that’s not spoken about, which is, their total returns aren’t good. One of these funds provided a negative total return once you factor in the capital appreciation. I’ll give you a hint; there’s been none.

These high yield ETF’s don’t follow a broad market index like the ASX200. The plan is usually more concentrated; for instance, VHY’s strategy is to buy stocks with the highest dividend yields and follow the FTSE Australian High Dividend Yield Index. HVST’s approach is to purchase high yielding stocks, collect the dividend income & franking credits, then sell the stock back to the market. This approach is also known as a dividend harvesting strategy since they’re harvesting the dividends.

When the total return meets high yield

I had purchased the ETF, VHY, with the anticipation of the high yield. Receiving the potentially high current cash flow had me excited (which wasn’t much, to be honest), I thought I’d stumbled onto a massive compounder with this ETF. After I made the first purchase, I began averaging in each month and sticking to the plan. But then the Coronavirus crash hit the markets, and this holding tanked at least 20% into the red. Even though the crashed produced indiscriminate selling, I couldn’t feel confident in this position bouncing back too well. So, I took some time out and had a look at the price chart of VHY.

It was here that I noticed the ETF had gone below the price it listed on the stock exchange. Looking at the chart below, you can see it’s more or less just bounced around for the past 9 years.

The point on the far left was when it listed on the exchange; the far right is current day pricing. The blue line represents how the price is back to where it started producing no capital gains.

Since there was no capital appreciation and, knowing dividends will be on the chopping block with public corporations because of the virus. It made me seriously rethink this position, and what the total return had been. So, I asked myself the question, what was the total return over this period? I had to do a little digging, but here’s what I came up with.

VHY returns since inception

The results weren’t that shocking, to be honest. My principal amount wouldn’t have moved much over the 9-years but once I factored in all the dividends paid the total return was 68%. Which on average, was a 6% return each year.

The columns you want to look at are total return and the annual rate of return.

Now if your goal was to receive an above-average dividend yield with diversification, then I think you can safely say this was achieved. Because there was no capital appreciation, and the only return was from the dividend yield, which was 6%.

Remember, in investing, everyone’s circumstances are different. One person might be happy earning that type of return while their principal hasn’t moved over this timeframe. And, another investor might not want anything like this in their portfolio.

So, what do I prefer? I’ve become more focused on total return, having capital gains plus dividends. Knowing this ETF has a higher chance of not producing capital gains or very minimal at best, I decided to sell this holding.

HVST Returns since inception

This ETF’s objective is to pay out a dividend yield that’s 1.5 times the market average. These high yields are enticing to investors or retirees who can receive significant cash distributions while in retirement. I almost invested in it myself chasing high current cash flow. But I passed on it once I checked out the price chart.

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HVST was first listed in 2014. Starting from the left side, it’s done nothing but go down in price since it’s listing.

Anyone could look at this and know their investment would have lost money. Imagine if you bought at $26 then sold at $13.26, your investment would have lost close to half its value. But what about the dividends paid, would they be enough to make up for the falling unit price?

And the answer to that question is no. With dividends included your total return would have been -4.5%. Yes, that’s correct, even with its high yield and all the dividends paid you would have lost money. You’d be looking at an annual loss of -0.51%.

To me, the case on HVST can be closed right here; I’m not interested🙅‍♂️.

High yield conclusion

I tried to make this summary an apples to apples comparison. This means I didn’t factor in dollar-cost averaging, reinvested dividends or franking credits. These would have made a difference with VHY, maybe around 1 to 2%, more than the 6% which I came up with. Betshares believes you would have made around 2% with HVST if you received all franking credit as cash. I struggle to see it making a difference; in my opinion, you would have lost money. There are just too many variables that need to line up for you to receive all that cash to make a positive return.

I view these ETF’s in the sense that, their design isn’t to give a total return. They’re trying to accumulate dividend income and return them to unitholders. The high yield attracts investors because they need less money to achieve their goals. For instance, a 6% yield would only take $700k to receive just over $40k in dividends each year. Whereas that same $40k would take a 1 million dollar portfolio with a 4% yield. From that perspective, it’s easy to see why investors chase the high yield.

These high yield ETF’s are complex securities, and you should do your research before you decide to invest in them. Look for the Product Disclosure Statement (PDS) on the funds’ website then search for their methodology. All funds (not just these high yielders) do a pretty decent job of explaining their strategies to prospective investors like us.

Have you invested in a high yield ETF before? Let me know in the comments below!

 

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