The Income ETF Mistakes Costing Aussie Retirees Millions
Transcript:
There are a whole load of ways to come unstuck looking for income in the Australian market. Ever since 2020, when interest rates were close to zero, the ETF market exploded with income-related, high-yield ETFs. And let me tell you, if you are relying on them for income, you could be making some huge mistakes. Come another global financial crisis, if you’re in the wrong ETF, there is a lot of risk. I’m going to run you through the criteria to filter out all the risky ETFs and to choose the best ETFs for income – and I will tell you what I would do if I was chasing income using ETFs as an Australian retiree. Let’s get into it.
What we’re going to do first is look at the types of ETFs and write off some of those that we’re not going to use for income. There are two basic types of ETF used for income. There are equity-based ETFs and fixed interest ETFs. The fixed interest ETFs are broken down into a few different types. There are bonds. Think of US Treasury bonds, global Treasury bonds, Australian Treasury bonds. Bonds are issued by governments. They are essentially risk-free unless the country goes bust – which is unlikely. And if it does, you’ve got other things to worry about.
I would not bother with any ETFs that are looking at overseas markets unless they were hedged. The last thing you want to do as an income investor is have a currency risk. When you’re dealing with income, you’re looking at anywhere between four to 6% as your return. And that’s what you’re trying to achieve at the moment. So, apologies to all those ETF issuers who have created these lovely ETFs over US bond yields and global bonds – if they’re not hedged, not interested. You can write those off. So we’re left with Australian fixed interest or hedged fixed interest ETFs.
Staying with fixed interest ETFs, the next issue is what type of fixed interest are they in? I’ve talked about the bonds issued by governments – they’re the best. The ones to avoid, in my humble opinion, are anything that is less than government grade. In other words, as we look down the list of fixed interests, we’ve got senior floating rate bonds, investment grade corporate bonds, corporate fixed interest. These are all lower-grade debt issuances that I wouldn’t bother to get involved with. It’s a matter of risk. In the GFC, you had some corporate fixed interest issues drop 30–40%. If we had another GFC, you cannot afford to be holding corporate subordinated riskier debt. The reason these ETFs have been created is to create a higher income for you. And in my humble opinion, a lot of that extra risk is exponentially larger for an incrementally larger yield.
The other group of ETFs – which are some of the largest and we use in our fund – are the cash and bills ETFs. The most obvious ones here are an ETF called BILL and an ETF called AAA. And AAA simply does what you could do yourself, which is deposit money into a diversified number of bank accounts that pay a deposit rate. You can sort of do that yourself. But it is the largest ETF in Australia in the fixed interest category, with $5.19 billion worth of assets under management.
And that is one of the best ways to sort ETFs as well – sort them by assets under management, also called market capitalisation in most cases. As we look for the top fixed interest bond market ETFs that are out there – cash and bills and bonds – AAA is the largest. VBND, which is the Vanguard Global Aggregate Bond Index, and that one’s hedged, which is why I’ve left it in. And then we have BILL with a $1.2–$2 billion market cap, which shows you that it’s well used as well. Size is a good gauge of whether this has been vetted by a lot of people and is used by a lot of people – how safe it is relative to some of the others.
Amazingly, as I look down the list of 70 fixed interest ETFs, when you get to the bottom of the list, ten of the 70 have a market cap below $10 million and half of them have a market cap below $100 million. If you’re looking for safety in numbers, you can write off half of the fixed interest ETFs straight away by virtue of their size. And big is better.
The benchmark that wipes out most ETFs
But let me tell you the most important part of looking to invest for income in ETFs – and that is, what’s your benchmark? This wipes out 50–60% of ETFs claiming to be high yield. Your benchmark is whatever you could get in a term deposit or a deposit saver account. And if you look at Macquarie at the moment, you’ll see that they are advertising a 5% return for balances under $2 million. That should be your benchmark. And I can tell you the majority of ETFs do not yield that much. You need to first of all compare any ETF yield to what you can get completely risk-free, hassle-free, no management fees, no spread, no market risk in your bank. So look at that first, then start to look at ETFs.
So once you’ve discarded 99% of the fixed interest ETFs because they don’t yield enough, the next group to come along and look at are the equity-based ETFs. And here you’ve got a chance of earning more than the Macquarie saver account – earning more than 5% – because some stocks yield more than 5%. But that straight away brings in another benchmark which will filter out 80% of the equity-based ETFs that are claiming to be high yield or dividend focused, and there are only 40 of them. Your first filter is to look at the ASX 200 and see what it yields. The A200 ETF paid 4.5% including franking over the last year on their website at the moment – 3.4% plus franking. So any ETF that doesn’t yield at least 4.5% including franking isn’t making it compared to the whole index. That’s one of your first filters. Does it actually pay more than the index?
The second filter is that you will find that most ETFs claiming to focus on the higher-yielding stocks – I really don’t want to name them because I don’t want to destroy the billions of dollars that are in them – but there’s one particularly very large Australian ETF in the equity space that focuses on ASX 200 higher-yielding stocks. Because it’s just higher-yielding and includes resources, which are higher-yielding one day and not the next and are unreliable, but if they happen to have a high yield that year on – I don’t know whose forecasts – they will include it. You have some income-based or income-marketing ETFs that are holding enormous amounts of non-yielding, highly volatile stocks, which just goes against the ethos of income investing. Which is: I don’t want volatility. I don’t want dividends that pay out one year and not the next. I need consistency. I need reliable income.
And so many of the ETFs that are purporting to be high-yielding are using non-income stocks in the traditional sense of reliable, consistent quality. So if you look at your high-yielding ETF and it’s got stocks like Woodside Petroleum (ASX: WDS), BHP Group (ASX: BHP), Rio Tinto (ASX: RIO), Fortescue (ASX: FMG) – because they might happen to have a decent yield – they’re extremely volatile stocks. They’re cyclical stocks and they shouldn’t be used or relied on for income, because the capital is moving so rapidly compared to other more stable income stocks.
How to filter equity-based ETFs
One of the other things to have a look at is how many stocks are in the ETF. I can tell you in any equity market there are maybe 20 – if you think a bit harder, ten – stocks that are quality income stocks. We’ve pulled them out in our income portfolio in the Marcus Today membership. You can have a look at those. If an ETF has got 100 stocks in it, they are clearly not filtering properly for income stocks. They are including a whole load of stocks that happen to have a high yield on some forecast or last year’s dividend. This is not a focused ETF focused on income. It is simply a “don’t sue us, we’ll include everything” ETF. And the likelihood is it’s doing exactly what the index is doing anyway – in which case, the only reason they’ve got high yield on the description is because they’re trying to market to people that want yield, not because they’re actually giving it to you.
The other filter for equity-based ETFs, just as with fixed interest, is size. There are a lot of ETFs that just haven’t made it. A lot of ETFs get started hoping they get traction, but their performance isn’t fabulous and they never grow – and there’s a reason they never grow. Anything with a market cap under $100 million, you’ve got to have a look. If they’ve been around for a long time, the likelihood is that they are not achieving their goals and haven’t convinced people to stay in them. If they’ve only been around a short time, then they’re still growing and that might be okay. But if you filter by under $100 million, out of 40 ETFs you’re going to get rid of ten or 15 of them.
The other way I would filter is active fund managers. Some active fund managers are very good at what they do and are very focused. Again, check the number of stocks. If an active fund manager’s got 100 stocks, they’re not actually doing any work. But an active fund manager who’s got five, ten, 15 stocks is pulling out the income stocks for you and it might well be a good ETF to be in. So I can’t write off all active fund manager-based ETFs – and you can spot those very easily because they haven’t got a major issuer behind them. So if it’s Global X, Betashares, iShares, VanEck, Vanguard – all those are algorithm-driven, haven’t got a fund manager behind them making decisions. That’s a passive ETF, as opposed to an active ETF where you’ve got a fund manager making decisions. If you have one, check they haven’t got 100 stocks – and if they haven’t, the likelihood is they’re doing some decent work.
What to look at once you’ve filtered
So after we’ve filtered by active or passive, by size, by number of shares, we get down to the obvious things you can now start looking at. And this is really a question of what you are after, what suits you.
The first thing of course is obviously what’s the yield. Every ETF issuer has a page which will give you all the details you need to know – it’ll tell you what the distributions are, what the yield was last year. You can start to pick up on which ones are meeting your criteria in terms of yield.
The other thing to look at is franking. Bonds don’t have franking. Fixed interest doesn’t have franking. But obviously Australian retirees are very interested in franking. You need to go to the individual websites of the individual ETFs and look at what’s the yield, what’s the franking. That is a personal preference. Some people in self-managed super funds are franking hungry – in which case, check it out first.
The next thing of course is management fee. ETFs are very cheaply run, most of them. Management fees are not a big issue. They’re very competitive, especially amongst the big issuers. They look at each other’s ETFs and undercut each other. The trend’s good that way. But just bear in mind, whatever you think the yield is, the management fee comes straight off it. So reduce the yield by the management fee.
The next thing I would look at is the performance relative to the ASX 200 as the benchmark. You want to see income stocks generally will underperform the ASX 200 when it’s going up and will outperform the ASX 200 when it’s going down. Income stocks tend to be defensive. But just have a look at the ETF relative to a benchmark and make sure it’s not consistently dropping over time, as some do. If you look at the net asset value or the price of the ETF, you might find some of them are just trending lower endlessly. That’ll filter out a few.
Probably the last thing to check – just to see if it suits you – is what is the frequency of paying out dividends. Some of them, especially the yield-based ETFs, do try and pay out regularly – so once a quarter. The payout in the Australian market, the ASX 200, is generally lumpy because of the results seasons. You get two big lumps and then you get the bank dividends in between. Just check out whether these ETFs smooth things for you – which is quite good for some people. Check out how often they pay. Most of them should be paying once every three months. So quarterly – four dividends a year – whatever suits you.
The ETFs that promise too much
I can’t name them, but there are some ETFs that promise you a really good yield and they pay you a really good yield – up to 9%. But where there is no income, there is no income. And the only way some of these high-yielding ETFs can pay you a yield which is higher than any dividend that any stock pays in Australia is because they’re effectively handing you back their capital. What happens is the price of the ETF constantly drifts as they pay out whatever dividends they’ve received, but they also pay you back some of your capital. It looks great, but the price is going down. So you’re swapping capital for income. That may suit some people – the total return isn’t that bad. But just be aware: for anybody who is looking to grow their nest egg, these are not the ETFs for you. Once you go and have a look at their share price charts, they become pretty obvious. So just look out for those. Nothing terribly wrong with them, especially as there is a level of franking attached to paying your capital back – but they certainly won’t suit people who are trying to make money and have a long runway through which they want to be earning income.
What I would actually do
So that brings me to what I would do if I was trying to achieve income through ETFs. There is one ETF that is just obvious to me and that is the MVB ETF, which holds the major banks, Macquarie, and Bendigo and Adelaide Bank and Bank of Queensland – and it pays a decent yield. It’s franked. I believe the banks are some of the best income stocks in the world, and our income portfolio is absolutely stuffed with banks. The banks are maybe a 25% weighting in the ASX 200. It just doesn’t make sense to put a lot of money in other stocks, especially if they’ve just got a high yield because they don’t have the quality, consistency, reliability – and they don’t have management that knows its responsibility to pay a decent dividend out to its shareholders.
The problem with it of course is that if a seismic moment came around for the bank sector – and they do come around. In the last 20 years, for instance, the global financial crisis in 2008 saw the bank sector drop 54%. The banking inquiry was seismic for the banking sector as well. They cut dividends and underperformed. So there are moments where you have to time the banks. And the reason to time them is not because they’re going to go wrong in the long term. It’s because there is a fantastic opportunity to sell them and buy them back lower down. And when they come out of a trough, they come out with accelerated returns in short periods of time. If you just sat in the banks after the global financial crisis, I think it was 11 years till they recovered their highs. You can use that instead of losing time – you can use that as an opportunity to time the banks and get back in, make accelerated gains, and you get this sort of step performance.
So what I would be doing if I was using ETFs for income is timing the MVB ETF – and only for seismic events. The problem with that of course is that you won’t know when to sell and when to buy back in. The obvious way you can follow when to buy and sell – because we’re all over it – is to get yourself a free trial to the Marcus Today membership. See if you like it. And should a seismic moment appear for the bank sector, we will be all over it. We are managing our income portfolio every day. We’ve got other income ideas outside of the banks and we time those as well.
So if you’re really looking for income through equities that beats a Macquarie saver account paying 5%, that’s probably the way to do it – sitting in the major banks, you get a good level of franking, a decent yield, and if you can time them well, the risk is a lot lower. That’s what I’d be doing if I was looking for income. And you can follow us doing it in the Marcus Today membership. Our other product – which is not income-orientated but ETF-orientated – is the MT20 managed portfolio, which has got $150 million in it at the moment. We can do it for you – https://marcustoday.com.au/managed-portfolios/