The income investing mistakes that are quietly costing Australian investors

Income generation has become an increasingly relevant topic in recent months, particularly as the changes to CGT has made many rethink their exposure to growth assets. Depending on personal circumstances, you could be better off putting your money into higher-yielding shares over growth-focused stocks.

As Betashares Senior Investment Strategist Cameron Gleeson explains, there are certainly going to be scenarios where the new settings will make income over capital gains more attractive.

But does that mean chasing yield above all else is the ideal strategy? Not quite.

“For most investors, yes, capital gains are likely generally to be more heavily taxed depending on that level of capital gains. But we shouldn't overstate the impacts here. It still makes sense to have an investment strategy that's going to create good long-term capital growth as well as income,” Gleeson says.

In the interview above, I spoke to Gleeson about the current state of play for income investing, the pitfalls that investors may face when searching for yield, and how they can avoid falling into these traps.

The income investing landscape

It’s no secret that Australia is undergoing a demographic shift as the population ages. In many cases, what that ageing population is looking for is income - and they’re doing it with ETFs.

Betashares data puts the number of investors between the ages of 44 and 65 years of age is now the largest cohort that own ETFs at close to 1 million.

“Predominantly in those age brackets, their number one investing goal tends to be income. That's the primary driver for a lot of these investors and so that's clearly going to be something that's front of mind,” Gleeson says.

“Whenever we have a new income-oriented ETF launch, we see a lot of engagement from that cohort.”

While he notes that young accumulators are less likely to be looking for income compared with pre-retirees, there is a desire among this group to create passive income that’s showing up in the data.

Driving the push for investors looking beyond the traditional methods of producing income, as Gleeson puts it, is that the other options are “not as attractive as they once were”.

“The ASX 200 index level dividend yield used to sit between 4 and 5% … that's now down to about 3.2%. So a real erosion of that yield you get from broad market equities,” he says.

“Of course, hybrids are slowly rolling off, and that's another form of security that a lot of investors used to really like for generating strong income. So with some of those options perhaps appearing less attractive, investors are looking for other solutions.”

Four traps catching income investors

Gleeson identifies three recurring mistakes investors make when they focus on yield. The first is capital erosion, where inflation essentially eats away at your wealth.

“If you look at a term deposit, if you're on the top marginal tax rate, you pay away a lot of the interest in tax. Inflation in this country is now over 3%. You may well be going backwards in terms of your net wealth if you're using just term deposits to generate income.”

The second challenge is reaching for yield and chasing the headline number without interrogating what's behind it. This can result in either taking on too much risk or getting caught in a dividend trap.

The third is concentration, with investors being so laser-focused on high-yielding stocks that they often end up with portfolios that are far too narrow, which compounds rather than reduces their risk.

There is also a practical timing problem that rarely gets discussed: “A lot of dividends are paid after earnings season, so they tend to be paid in September and in March. What are you going to do for the rest of the year?"

Smoothing out the lumps

There are options for investors looking to get around the lumpiness of dividends being paid this way, such as simply using a bucketing strategy to collect all of their earnings season dividends and holding onto it, drawing down over the course of the year.

“The issue there becomes that you're not necessarily having that money in markets and compounding that wealth. You're not taking advantage of that market's compounding power and you get a bit of a cash drag, if you like,” Gleeson explains.

The alternative, he adds, is to instead invest in a fund or an ETF that generates income quarterly or biannually but streams this out in the form of monthly distributions, such as the Betashares S&P Australian Shares High Yield ETF (ASX: HYLD).

“We see that as a really strong solution. It's not just about generating a high level of income, but it's about creating consistent income and there's lots of ETFs that can allow you to receive that regular income.”

Avoiding the dividend trap

Too often, investors chasing yield can get caught in a dividend trap, where a stock looks attractive based on its historical dividend yield but the current fundamentals don't stack up in support of its trailing yield.

“It might look really attractive, but the risk is that the number's very high because the market's pricing that the stock's going to disappoint on its earnings announcement and cut its dividend. The investor ends up losing both in terms of lower income and a capital loss,” Gleeson explains.

The solution isn't to avoid high-yield stocks entirely, but to use forward-looking signals rather than historical ones. Analyst consensus estimates of future dividends are likely to be a better measure, but he warns this isn’t perfect.

“Even those estimates can be out and companies can surprise on the downside. So there's also the opportunity to look for market signals. What's the stock price doing? Is that stock showing poor stock price momentum? Is it falling substantially? Is it overly volatile?

“Has that stock got a dividend yield of perhaps 15%? It sounds unsustainable that a stock could have a dividend yield of 15%. It's perhaps telling me that stock is not going to be able to pay out next year what it did last year, or indeed what analysts are forecasting.

“These are all ways of taking market information into account to reduce or weed out the probability that the stock may in fact disappoint.”

The good news, according to Gleeson, is that solutions exist, they just require a more considered approach than simply sorting stocks by yield and buying the top of the list.

"Not relying on historic dividends, using forward dividend estimates, but overlaying those market signals, screening out the worst performing stocks, screening out stocks that are overly volatile or have excessively high yields.

"Doesn't sound like a lot, but if you can take out some of those stocks, you increase your chance of removing a dividend trap from your portfolio."

ETF

Betashares S&P Australian Shares High Yield ETF (HYLD)

Australian Shares

View