Income Investing Is Not the Problem
Income investing is not the problem, it can provide an investor with cash flow and remove some decision-making, which can be beneficial. But there are things it cannot do that some investors assume it can, and I believe that is largely due to how many funds are marketed and the rise of social media.
Older income investors have seen this before. A long time ago, many funds were playing with higher distribution rates, and many of the problems that people are now seeing with covered call funds are not new. People just have short memories and do not look at the past, so we are dealing with a similar issue once again.
A distribution rate is not the same thing as income, and the way to know whether your fund is producing enough return to support its distribution is to look at total return. The problem is that total return is a trailing metric. We don't know in advance whether the fund will earn enough to support its distribution rate, and there can be periods where a fund is crushing it and other periods where it goes through years of underperformance.
It can be the same fund. While the fund you are investing in today might be killing it, in a year or two it might not be, and that could be due to any number of reasons. The more thematic the fund is, the more likely money is to move in and out of that sector compared with a fund that is more broadly diversified.
I've seen two posts recently that show one of the biggest problems in income investing: investors misunderstanding distribution yield and total return.
One post was from an investor who said they were already generating about $1,200 a month from covered calls and believed that would allow them to retire much sooner with far less money invested than people normally say they need. This is something that is often pushed by retail investors, and I have yet to see a fund company come out and say anything similar. They generally talk about total return as well. That is more than likely related to the regulatory constraints they operate under.
The second post was much more intentional. The investor named specific funds and said their goal was to eventually generate $400 a month in distributions to pay their car insurance. That example is easier to look at because we can actually take the fund, its distribution, the amount being invested, and start to see where the math begins to break down.
The fund currently pays $0.255 per share twice per month and is trading at $22.82, giving it a current annualized distribution rate of about 26.8%. They want to generate $400 a month to pay for their car insurance.
Starting with an existing portfolio of about $1,280, adding $100 every two weeks, and reinvesting all of the twice-monthly distributions, the portfolio could theoretically grow to around $18,000 in roughly 3.5 years if the share price stayed around $22.82 and the $0.255 distribution remained unchanged.
Those last two points are important because since the fund launched in this current bull market, the unit price has dropped about 8%, and the distribution has already been reduced once.
Now fast-forward and assume they dropped the whole amount in today and were generating $400 a month. If they withdrew the full $400 every month, that would be $4,800 per year, or almost 27% of an $18,000 portfolio.
For that withdrawal rate to be sustainable without steadily consuming the portfolio, the investment would have to generate roughly that amount through actual total return over time. Simply distributing 27% does not mean the portfolio earned 27%.
There was a recent YouTube video where the person mentioned seeing an ad showing a 13% distribution yield and thinking, "How is this possible?" They investigated, learned about covered calls, decided that it was possible, and so began their journey.
Not once while they were telling the story did they mention looking at the fund's total return or even talking about it, only the advertised distribution yield. That is the exact issue that has been a long-standing problem in the income investing space: focusing on how much a fund distributes without first asking how much the investment is actually earning.
Fund companies, when they go on interviews and sit on panels, often tell investors to look at total return and not just the distribution yield. There is a whole thing about not making portfolio decisions based on the distribution yield. Yet many funds are marketed heavily using the distribution yield rather than total return.
That is somewhat understandable because future total return is unknown and historical total return is a trailing metric. You could have a great total return for a few years, and then it could be horrible and the fund could erode its NAV.
Retail investors become very effective marketers for these products. They can make aggressive or just plain ridiculous claims about what is sustainable, focus entirely on yield, and build entire YouTube channels or social media accounts around how much "income" a portfolio produces. Fund companies are incentivized to gather more assets under management because that generates more fees, and they can benefit from that attention without directly making those claims themselves. They can appear on those channels and talk about total return without substantiating the creator's claims, but simply appearing can make it seem like they support them.
Looking at your portfolio and saying it pays you $5,000 a month means nothing if you have to reinvest the full $5,000 to maintain the capital.
I know there are a lot of people who do not like Adriano or his investing style, and I would call him more of a covered call investor than an income investor since he doesn’t really diversify his sources of income. But on his channel, at least, he isn’t making ridiculous claims. He continuously mentions that total return is what matters. He walks people through how to calculate the total return and while you might not agree with how he invests or what he invests in at least you can’t say he’s out making outlandish unsupported claims about what income investing can actually do.Â
If your total return over time is sufficient to support the amount you are spending, you can make the strategy work. Could you have made more investing in another fund with uncapped upside? Sure. But will the portfolio still support your spending? If the answer is yes and that fits your lifestyle, then who cares?
The problem is when you are watching channels that aren’t looking at the fund’s total return at all. They are talking almost entirely about the yield and basing their investment decisions on the fund’s advertised distribution rate. That isn’t doing anyone any favors.
At the end of the day, income investing is not the problem. The problem is confusing the amount a fund distributes with the amount the investment actually earns. There is nothing wrong with wanting cash flow, using covered calls, or choosing a fund that pays a higher distribution if it fits your goals. But the distribution itself does not tell you whether the strategy is working.
