One of the greatest concepts ever is retiring and simply living off the dividends. No work, no tasks, just big steady distributions rolling in like clockwork (for you to spend and live life however you please). The problem with this, of course, is that many investors end up chasing after the biggest yield opportunities without properly considering the quality of those yields. In this report, we introduce our “Big-Yield Quality Scores,” ranking 10 very popular big yields (including PDI, JEPI, SCHD, USA, ARCC, AGNC and more).
Big-Yield Quality Scores:
As you can see in the table below, we have ranked 10+ popular big yield strategies according to 5 categories and one overall “is this opportunity worth considering” score. Simply put, the idea is that low quality big-yields (“red”) should be avoided because they will likely reduce your bottom line net returns by significantly more than the big yield is actually worth. And high-quality big-yields (“green”) should be considered (if you are an income-focused investor).
Said differently, when the distribution is “not quality,” the opportunity cost is much greater than many investors realize or care to admit. Avoid low quality distributions. Here is an explanation of why, using several popular big-yield examples.
Liberty All-Star Equity Fund (USA), Yield: 10.0%
The Liberty All-Star Equity Fund is a popular big-yield fund that guarantees a 10% annual distribution yield (2.5% each month). And while that sounds amazing, a look under the hood reveals (if you haven’t already guessed) the distribution is sourced from a small amount of dividends and a large amount of captal gains.
And as we wrote about in our recent detailed USA report, this fund basically tracks the S&P 500 minus the high 0.93% annual expense ratio on USA. Further, there is really nothing special about USA (it doesn’t use leverage, it doesn’t trade at a big discount, and the holdings are not special—again it owns stocks and it’s performance is essentially the same as the S&P 500 minus its big expense ratio).
We assign USA a distribution quality score of 2.6 (avoid) in the table above because there are better ways to achieve the same results. For example, there are equity funds that generate essentially the same performance, but with lower fees and trade at a much more attractive price discount, such as the one we wrote about here: Big-Yield (8%+) Equity CEF: Big Discount to Narrow.
*Vanguard S&P 500 Index Fund (VOO), Yield: 1.4%
As another alternative, you can just buy a super low cost S&P 500 index fund, such as VOO, and then create your own 10% distribution, which will be better than USA because the annual fee is nearly 1% less (that’s another 1% return you can spend each year). Granted the VOO strategy requires a little elbow grease (you actually have to sell some gains from time to time), but VOO is also more tax efficient (i.e. you can sell to harvest capital gains and losses at your discretion to optimize your annual tax liability) instead of having USA do much of that for you without optimizing your personal tax situation. Advantage VOO (if you have the time to sell a few shares/gains from time-to-time, VOO is a better).
Other Quality Score Ratings
Tax Efficiency: As you can see in the table above, bond funds generally receive weaker tax efficiency scores because their interest is taxed at ordinary income rates (higher) instead of qualified dividends or long-term capital gains (both taxed at lower rates). But if you own in a tax-advantaged retirement account (such as an IRA), then the taxes don’t really matter in the same way.
Strategy Efficiency: Also, names like JEPI (synthetic stock market covered calls strategy) and AGNC (a highly-leverage (dangerous) mortgage REIT) rank poorly in the “strategy efficiency” category because their approach to generating high income is less than optimal. For example, JEPI sacrifices a lot of long-term total returns to reduce volatility and increase yield (and there are better ways to better optimize your income versus risk). And in the case of AGNC, they use so much leverage on their balance sheet that they end up getting in trouble once every market cycle (or so) when they get painful “margin calls” (due to market volatility) that causes them to lock in losses and do permanent damange to the value of their balance sheet (there are better ways to optimize your income versus risk than these two highly-tempting but inefficient strategies).
Unique Value: And in the unique value category, names like PIMCO’s big-yield bond fund (PDI) rank very well thanks to the unque value from their economies of scale (they can buy bonds you and I typically don’t have access too), they can apply leverage to magnify returns at lower rates and more efficiently (they have teams in place) than you or I could. And PIMCO is the best in the bond fund business (i.e. they add unique value).
The Bottom Line:
Just because something offers a big yield doesn’t mean its a good investment. And don’t let someone dupe you into believing the yield is so big that it will more than offset any small price declines. The reality is that the markets are somewhat efficient, and if something offers a huge yield it often also comes with huge risk.
By paying attention to big-yield “Quality Scores” you can eliminate some popular yet sub-optimal strategies, while instead focusing on names that are worth considering (depending on your personal goals and situation).
Disiclined, goal-focused, long-term investing continues to be a winning strategy. And at the end of the day, you need to do what is right for you.