Don’t Fall for This Common Dividend Mistake When Investing for Retirement

In addition to common behavioral biases, such as recency bias, affinity bias, and anchoring, many investors—and I count myself among them—compartmentalize and engage in mental accounting. One prime example of this is the tendency to think about dividends and yield in isolation, without considering total return or capital losses. A previous article discussed the appeal of prioritizing immediate income when investing for retirement; here, I’ll address the main downside.

Simply Irresistible?

Dividend payments, by themselves, don’t increase your net worth, but there are multiple reasons, beyond the scope of this article, why some investors might prefer an equity portfolio that yields more than the overall market. For investors in or near retirement, securities with yields that approach double digits can be especially seductive, as they can dramatically increase spendable income and/or reduce the size of the portfolio needed to reach a certain level of income. (Sometimes, it’s more than “approaching” double digits—I received an email solicitation this morning from an investment service touting an unnamed security that “makes it possible to SKIP decades of compounding” because of its 92% yield!)

Stretching for yield certainly isn’t a new phenomenon. Investors have been warned for decades about avoiding “dividend traps,” and Morningstar mutual fund analysts were writing about the issue of net asset value erosion back in the 1990s, as some fixed-income funds maintained or boosted their yields by returning capital to shareholders.

There are securities that generate above-average yields without sacrificing total return. Schwab U.S. Dividend Equity ETF SCHD, for example, which tracks the Dow Jones U.S. Dividend 100 Index and receives a Morningstar Medalist Rating of Gold, is popular among the income-first investing crowd. It has outperformed its Morningstar Category (US large-value funds) over the past 10 years on a total return basis while also generating a yield approaching 4%.

However, the relatively recent emergence of “covered call” exchange-traded funds with amplified yields has changed the landscape. Funds such as JPMorgan Equity Premium Income ETF JEPI and JPMorgan Nasdaq Equity Premium Income ETF JEPQ trounce the yields of traditional dividend funds and exchange-traded funds, and both are extremely popular with the income-first crowd. The former owns stocks from the S&P 500 while systematically selling one-month calls on the index, while the latter does the same for the Nasdaq-100 Index. JPMorgan Equity Premium Income ETF’s 12-month trailing yield stands at 8.4%, and JPMorgan Nasdaq Equity Premium Income ETF’s reaches double digits, at 10.6%.

But there’s a trade-off for those yields, as Daniel Sotiroff, a senior manager research analyst for Morningstar, explained in a podcast interview with Ivanna Hampton: “… you’re earning that income from the option premium, but the option essentially is adding a cap on that underlying asset and how high it can grow, and that’s basically the mechanism that’s at work here. And because of that cap, the total return on your covered-call ETF is more than likely not going to outperform the underlying asset.”

That’s the case with both of these popular ETFs. As seen in the following two exhibits, the since-inception total returns for both fall far short of the total returns of ETFs based on the respective underlying indexes.

In addition to covered-call ETFs based on broad-market indexes, there are now single-stock option-income ETFs. Some of these securities have truly eye-popping yields, but as Morningstar’s Jeff Ptak recently observed, most of them have generated worse total returns than simply holding a 67/33 mixture of the stock in question and cash. He also noted that “the ‘yield’ these ETFs tout appears to be a financial sleight of hand. The manager can more or less choose the monthly or weekly distribution rate. Then it’s a simple matter of multiplying that rate by 12 and dividing that product by the most recent NAV. Just like that, the ETF has a huge ‘yield.’”

Another example of a stratospheric yield is YieldMax Ultra Option Income Strategy ETF ULTY, which has a trailing 12-month yield in excess of 100%! Though as Morningstar portfolio strategist Amy Arnott noted, a large portion of the fund’s recent distributions is classified as returns of capital and “a fund can’t continuously distribute more income than it earns without eroding shareholder value.”

Make an Informed Decision

As noted in the previous article, opting to give up a portion of a portfolio’s potential total return in exchange for higher current income may be a reasonable trade-off for some investors, especially if they’re trying to live off their portfolio’s income. But they should know, going in, that their total return is likely to lag, and that the yields of some investments are simply unsustainable.

To be fair, many adherents of the income-first approach seem well aware of the total return versus yield argument. Further, it’s impossible to predict the relative success of any investment strategy. For some of these investors, an investment approach that prioritizes dividends and income may result in a larger retirement nest egg (and income stream) than they might have achieved with a more traditional approach, especially if a virtuous circle component (seeing their growing income stream) causes them to invest at a significantly higher rate than they otherwise would have. But it’s also likely that some investors choosing securities based solely on yield will instead end up with smaller portfolios and less spendable retirement income. Given the allure of higher payouts, however, I expect there will be no shortage of investment offerings that cater to investors’ desire for yield, even when much of that “income” turns out to be a return of the capital they invested.