Total Return Investments vs. High Yields: Yield Chasing at Your Own Peril

May 21, 2024 | Dividend, ETFs, Income, Investing, Investment Portfolios, Investments, Mutual-Funds, Newsletter

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Total Return Investments vs. High Yields: Yield Chasing at Your Own Peril

In the world of investing, the allure of high yields can be intoxicating. The promise of consistent, substantial returns is hard to resist, particularly for people like retirees who are seeking income. However, not all yields are created equal, and focusing solely on yield can lead to suboptimal investment outcomes. In this article, we will explore the different types of yields and why total return is a more comprehensive measure of investment success. We’ll also discuss tax implications that investors should consider.

Understanding Different Types of Yields

When it comes to yields, investors often have warm and fuzzy feelings because steady cash distributions provide a sense of income. On the other hand, capital appreciation or price changes in investments are more abstract; after all, prices can change on a whim due to volatile markets. This perception holds true to an extent. However, precisely because of investors’ desire for income, financial companies work hard to create various income investment securities (mostly funds) to boost yields or ‘income’. Let’s first understand different types of yields out there in the markets.

1. Stock (Fund) Yields Stock yields typically refer to the dividend yield, which is the annual dividend payment divided by the stock price. While dividends can provide a steady income stream, high dividend yields can sometimes indicate underlying problems with the company, such as declining stock prices or unsustainable payout ratios.There are many solid companies that have maintained and grown yields over times. Examples include JP Morgan (JPM), Coca-Cola (KO), Apple (AAPL) and Home Depot, However, many companies are forced to cut dividends over times or have to resorted to pay out dividends that caused negative cash flow which can’t sustain. Representative stock ETF funds are like Vanguard Dividend Appreciation ETF VIG or Vanguard High Dividend ETF (VYM).  Currently VIG yields 2.1% annually. 

2. Bond (Fund) Yields Bond (fund) yields represent the interest income generated by the bonds within the fund. This yield can be appealing, especially when bond prices are stable or rising. However, bond yields can be affected by interest rate changes and credit risks associated with the underlying bonds.

3. Manufactured Yield Type 1: Option-Generated Yields Option strategies, such as covered calls, can generate additional income (yield) from stocks or ETFs. While these yields can enhance returns, they also cap the potential upside and can introduce significant risks, especially in volatile markets. One of the most popular ETFs is JP Morgan Premium Income JEPI that has accumulated over $33 Billion asset under management. The investment strategy of JEPI is that it holds a diversified high conviction stocks and then sells (or called writes) S&P 500 index options to generate extra income. Currently JEPI yields 7.6% annually, way above VIG’s 2.1%!

4. Manufactured Yield Type 2: Leveraged Bond or Stock Fund Yields (e.g., Closed-End Fund Yields) Leveraged funds use borrowed money to amplify returns, which can result in higher yields. However, leverage increases the risk of losses, especially during market downturns. Closed-end funds, in particular, can be subject to significant price volatility and liquidity risks. There are also a lot of leveraged funds that try to deliver high income. An example is PIMCO dynamic income closed fund (PDI). 

5. Manufactured Yield Type 3: Distributions: Return of Capital and One-Off Capital Appreciation Some funds distribute returns that include a return of capital, which is essentially giving investors back their own money. This can make the yield appear higher than it truly is. One-off capital appreciations, such as special dividends or capital gains distributions, can also distort yield figures.

The Primacy of Total Return

Regardless of the extra cash or income you receive from your investments, you still need to monitor your investment’s price. It’s understandable that some investors don’t want to touch the principal or the underlying investments, but if your principal value keeps declining, your overall asset value declines as well. Therefore, it’s important to take a holistic view of your investments. This is where the concept of total return comes in, which includes both income (dividends or interest) and capital appreciation. On a logistical note, to withdraw a certain amount of income from your investment, you can always sell a portion of the investment to generate the cash.

MyPlanIQ has adopted the concept of total return throughout our funds and portfolio return and risk measurements. A precise definition of total return is that it includes the actual return of the underlying investment value with its dividends or distributions being reinvested immediately once distributed. This overall total return allows for an apples-to-apples comparison of fund or portfolio performance. Of course, you can still look at dividend yields to compare yields alone.

Now let’s take a concrete look at some of these (high) yield investments

Total returns of high yield stock funds 

Dividend Stock ETF Total Return Performance Comparison (as of 5/17/2024):
ETF Latest yield YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 15Yr AR
SDIV (Global X SuperDividend ETF) 11.4% 6.3% 19.0% -8.9% -6.1% -3.5%  
JEPI (JPMorgan Equity Premium Income ETF) 7.6% 6.8% 13.2% 7.8%      
VIG (Vanguard Dividend Appreciation Index Fund ETF Shares) 2.1% 8.5% 20.6% 8.0% 12.7% 11.5% 13.3%
VYM (Vanguard High Dividend Yield Index Fund ETF Shares) 3.3% 9.5% 21.2% 7.4% 10.6% 10.0% 13.0%
XYLD (Global X S&P 500® Covered Call ETF) 9.4% 5.5% 8.4% 4.7%      
PUTW (WisdomTree CBOE S&P 500 PutWrite Strategy Fund) 10.2%(4.6%) 9.0% 16.5% 8.5% 8.3%    
SPY (SPDR S&P 500 ETF Trust) 1.6% 11.7% 29.4% 10.0% 15.0% 12.9% 14.8%

For more dividend details, visit this comparison link and scroll down to the detailed table and scroll to the bottom in the table to find out calendar year and last 1, 3, 5, 10 year dividend yields. 

In the above table, 

  • SDIV (Global X SuperDividend ETF) : The ETF boasts a whopping 11.4% annual yield without using leverage. It primarily seeks high-yield stocks globally. Currently, for example, its top holding is Yue Yuen Industrial Holdings, a stock listed on the Hong Kong exchange. Despite consistently delivering an average yield of around 7% (and at least 5% each year) since its inception in 2011, its total return has been underwhelming. In fact, over the past 10 years, it has had an annual total return of -3.5%! So, despite the attractive yield, an investor focused solely on this high-yield ETF has seen their investment cumulatively lose 30% over the past 10 years.
  • JEPI (JPMorgan Equity Premium Income ETF): This ETF is perhaps one of the best among those that utilize derivatives such as options to generate income. There has been a flurry of such ‘high income’ ETFs in the market, aiming to entice income seekers. Other notable examples include the XYLD (Global X S&P 500® Covered Call ETF) and PUTW (WisdomTree CBOE S&P 500 PutWrite Strategy Fund). Both of these ETFs sell S&P 500 call options (with the underlying being S&P 500 index portfolios such as SPY) or sell S&P 500 put options.
    • While these yields are high, or even extremely high, their total returns still tend to be lower than the S&P 500 total return (SPY), sometimes significantly so (XYLD 4.7% in the past 10 years vs. SPY’s 10%). For instance, despite generating substantial yields, these funds often lag behind in terms of overall performance due to the limited upside potential and increased risk associated with their options strategies.
  • VIG (Vanguard Dividend Appreciation Index Fund ETF Shares) and VYM (Vanguard High Dividend Yield Index Fund ETF Shares): These two plain vanilla dividend ETFs, even though delivering much lower yields (2-3%), their total returns are still reasonably comparable to SPY’s. 
  • Other high income ETFs such as QYLD (Global X NASDAQ 100 Covered Call ETF) has substantially underperformed its QQQ equivalent — for the past 10 years, it had annualized total return 6.9%, compared with QQQ’ 18.9%, a 12% annual difference. See this link for more details. 

What about for bonds? Let’s take a look at leveraged closed end bond funds vs regular bond funds:

Closed end leverage bond fund vs regular bond fund: 
Ticker/Portfolio Name Max Drawdown YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 10Yr Sharpe
PDI (PIMCO Dynamic Income Fund) 46.5% 13.1% 22.5% 0.8% 2.3% 7.5% 0.34
PONAX (PIMCO INCOME FUND CLASS A) 13.4% 1.2% 7.4% 0.9% 2.5% 3.7% 0.65

The PDI fund employs 39% leverage, meaning it borrows an additional 39% of its capital to invest in corporate and other bonds. This leverage contributes to its high annual yield of 14.6%, compared to PONAX’s 6%.

Over the past 10 years, PDI has delivered significantly better total returns: 7.5% versus PONAX’s 3.7%. However, this higher return comes with increased risk. PDI experienced a maximum drawdown of 46.5%, compared to PONAX’s 13.4%. To put this in perspective, the SPY (S&P 500 index fund) had a maximum drawdown of 33.7% over the same period. Therefore, it can be safely claimed that PDI’s volatility is actually higher than that of a stock fund. This is evident from the following total return chart:

The huge ups and downs in the PDI total return chart are not for an income seeker with a faint heart!

Tactical High Dividend Strategy

On the other hand, we can utilize MyPlanIQ’s Composite Market Momentum strategy that’s employed in P Composite Momentum Market VFINX listed on Advanced Strategies page to a dividend fund such as VYM (Vanguard High Dividend Yield Index Fund ETF Shares) to reduce risk and improve total returns:

Portfolio Performance Comparison
Ticker/Portfolio Name Max Drawdown 1Yr AR 3Yr AR 5Yr AR 10Yr AR 15Yr AR Since 1/2007
P Composite Momentum Market VYM With Total Return Bond Funds As Cash 35% 21.2% 7.4% 10.1% 9.3% 12.7% 11.2%
VYM (Vanguard High Dividend Yield Index Fund ETF Shares) 57% 21.2% 7.4% 10.6% 10.0% 12.8% 8.3%
VFINX (VANGUARD 500 INDEX FUND INVESTOR SHARES) 55% 29.3% 9.9% 15.0% 12.9% 14.6% 10%

So the tactical portfolio has outperformed VFINX (Vanguard 500 Index Fund) since its inception in 2007 (noting that VYM, the Vanguard High Dividend Yield ETF, was launched in November 2006), despite experiencing a maximum drawdown or interim loss of 60% of the VFINX’s. 

Tax Efficiency Considerations

Income investors seeking yields should be also aware that they are subject to various tax treatments, which can significantly impact net returns. For instance:

  • Qualified Dividends vs. Ordinary Dividends: Qualified dividends are taxed at the lower capital gains tax rate, whereas ordinary dividends are taxed at higher ordinary income rates.
  • Interest Income: Interest from bonds and bond funds is typically taxed as ordinary income.
  • Return of Capital: Distributions classified as return of capital are not immediately taxable but reduce the investor’s cost basis, leading to higher capital gains taxes upon sale.
  • Option Income: Income from options can be complex, involving various tax treatments depending on the type and timing of the option. In general, if the income or yield is generated from an index option, such as call option premiums for the S&P 500 index, the income is typically treated as 60% long-term capital gain and 40% short-term capital gain. However, if the income comes from stock options, it is usually treated as short-term income, or ordinary income.

The takeaway

From the above discussions, we can conclude that it’s not a good idea to solely focus on yields. Instead, it’s important to take a total return approach that combines both price appreciation and dividends. Don’t be swayed by ‘high yield’ funds or fancy income mechanisms. A simple approach that invests in solid dividend funds like VIG (Vanguard Dividend Appreciation ETF) or VYM (Vanguard High Dividend Yield ETF), coupled with a tactical strategy to reduce interim loss or maximum drawdown, can provide a much better and steadier capital base that can be converted to income if necessary.

Market Overview

As the first quarter’s earnings report period draws to a close, Factset’s data as of May 17, 2024, reveals that S&P 500 companies, with 93% having reported actual results, recorded a 5.7% blended earnings growth for Q1 2024. This growth has alleviated some investor concerns regarding an earnings slowdown.

On the other hand, recent economic data points to a potential cooling period. In addition to a higher unemployment rate in April, both retail sales and industrial production have registered year-over-year declines. These indicators suggest that the economy might be slowing down, which could eventually push the Federal Reserve to consider reducing interest rates to ease financial conditions.

As a result, both stocks and bonds have risen in prices. However, we find ourselves in a delicate situation: if interest rates remain high for too long, it might be too late to prevent a potential recession, but acting too early could rekindle inflation. This balancing act highlights the ongoing challenges facing policymakers in maintaining economic stability.

As always, we claim no crystal ball and we call for staying the course which is guided by the well defined and sound strategic and tactical strategies:

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as we have emphasized numerous times when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years, preferably much longer, given the current high valuation. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later and preferably many more years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially during this time. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This is true time and time again.

Stock valuation has dropped, and now valuation is becoming less hostile. However, it is still not cheap by historical standards. For the moment, we believe it’s prudent to be extra cautious. However, how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of market is through dollar cost average (DCA), i.e., invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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