How to avoid the ‘yield trap’ when it comes to investing

Amid growing concerns about stock market volatility and low interest rates, many investors are re-examining the income-generation strategy they’ve chosen to fund their retirement.

Market stress, coupled with the impact of our ageing population that means most older Australians are facing a much longer retirement period than their own parents enjoyed, has led investors to look towards high-yield-orientated investments.

High-yield equity investments have the potential to enhance overall portfolio performance and boost income. This is because the dividend income associated with high-yield investments are typically income strategies that deliver sustainable returns over a long period of time. This stability ensures that high-yield focused portfolios can match or outpace the broader market performance, especially during periods of market volatility.

There are certain risks, though, associated with chasing high returns on investments.

One risk is the potential for investors to fall into a yield trap. A yield trap is simply a dividend yield that is ‘too good to be true’ – that is, investments that promise higher returns but place your capital at risk. In order to mitigate a yield-trap scenario, other than ensuring that it is a part of a well-diversified portfolio, is to invest in high-quality funds with proven track records.

How to pick a quality income investment

Quality measures gained popularity after the burst of the dot.com bubble and the spectacular failures of some high-profile companies. More recently the Global Financial Crisis and bouts of market volatility has renewed interest in quality measures.

A quality fund is sourced from a company with low debt, stable earnings and high profitability. These are high-yielding companies that have increased or maintained their dividend yields over an extended period of time. Typically, quality funds consistently perform well because their managers are focused on the sustainability of the dividend yield over time rather than just the size of its return, providing long-term income generation.

A low interest rate environment in Australia, as well as the poor performances of local resources and banking stocks, has led many Australian investors to look overseas to build a yield-oriented portfolio. But selecting high performing stocks abroad can often be time consuming, difficult to research and challenging to access for Australian investors. A simple way to overcome these challenges and access quality funds abroad is to consider exchange-traded funds (ETFs).

How ETFs can broaden your horizons

An ETF is a basket of securities that investors can buy and sell on stock exchanges, just like any other share. An ETF usually aims to track the performance of an index, such as a sector or a market, in an efficient and a low-cost way.

ETFs allow investors to generate income in a similar way to holding a whole portfolio of investments, but with just one trade. Like individual shares, ETFs collect dividends from the securities they hold. When these securities pay dividends, investors in that fund stand to gain dividend payments from a broad array of companies and sectors.

ETFs also play an important role in generating income through diversification. This is because they spread an investment across a range of sectors and markets, meaning that investors can reduce the risk that comes with individual stock-picking.

A global dividend ETF can be a simple, effective tool for investors to access the benefits of quality, high-yielding stocks, which can help create a sustainable and diversified income stream through a single investment.

One ETF that provides access to quality stocks with consistently high yields is the SPDR S&P Global Dividend Fund, or WDIV, run by State Street Global Advisors, which has grown over more than 40 years into one of the world’s largest investment managers. Accessible to Australian investors via the ASX, this fund holds high-yielding companies that have increased or maintained their dividend yields for at least 10 consecutive years from the S&P Global Dividend Aristocrats Index.

The Aristocrats Index is designed to measure the performance of the highest dividend yielding companies within the S&P Global Broad Market Index. It includes some of the best-known companies in the world, including, at present, the advertising giant WPP, US telco AT&T and high-street fashion chain Hennes & Mauritz, which you may know better as H&M in your local shopping centre.

The fund worries about diversification, not you

The diversification of ETFs means that investors who are looking to generate income are able to access the dividends from all the underlying securities of the ETF. A large proportion of dividends in Australia are contributed by a handful of Australian companies. But in a global divided fund containing quality stocks, there is less of a chance that specific companies or sectors dominate.

WDIV as an example offers exposure of up to 100 securities around the world across a variety of sectors including financials, utility stocks and real estate. In this index no single stock exceeds 3 percent weight, while sector and country weights are capped at 25 percent and no more than 20 stocks may be held from any one country. This level of diversification in a portfolio can help investors to guard against risk and ensure more stable income growth through investing in different markets.

To generate income during these periods of market stress, investors can look towards quality companies with sustainable dividend yields rather than those that promise large returns. For many investors, an ETF containing these quality companies is a low-cost, simple method in order to establish a stable income stream as a part of a diversified portfolio.

Are you familiar with ETFs? Have you used them to build your retirement income?

Important information: The information provided on this website is of a general nature and for information purposes only. It does not take into account your objectives, financial situation or needs. It is not financial product advice and must not be relied upon as such. Before making any financial decision you should determine whether the information is appropriate in terms of your particular circumstances and seek advice from an independent licensed financial services professional.