High Income Investments: A Warning | Summary and Q&A

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December 5, 2023
by
Ben Felix
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High Income Investments: A Warning

TL;DR

High distribution yields do not necessarily indicate high investment returns, and they can often mislead investors.

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Questions & Answers

Q: Why are distribution yields often emphasized when marketing investment products?

Distribution yields are attractive to investors because they indicate potential income. Financial product manufacturers use high yields to market their products and attract investors, especially the unsophisticated ones.

Q: How do high distribution yields in covered call funds affect their expected returns?

In covered call funds, the high yield is mostly derived from option premiums. However, writing options on the fund's holdings limits the upside potential of the stock portfolio, resulting in lower expected returns compared to the underlying stocks.

Q: Are structured products with high headline rates of return good investments?

No, the high headline rates of return in structured products often do not align with their expected and realized returns. These high rates are used to attract investors based on yield without considering the actual investment's returns.

Q: How do equity mutual funds artificially drive up their yields?

Some equity mutual funds intentionally buy stocks before dividend payments to increase their dividend yield. This artificially inflates the fund's yield and attracts investors, particularly those seeking higher yields.

Summary & Key Takeaways

  • Many investment products are marketed based on their high distribution yields, but these yields do not necessarily have any relationship to expected returns.

  • Investments with high distribution yields may actually have low expected returns and can be tax inefficient.

  • Covered call funds, structured products, and equity mutual funds often use high distribution yields to attract investors, but their total returns may underperform.

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