The Greatest Lie in Income Investing
Math is math. You cannot spend more than you earn forever, and the same principle applies to income funds. A fund cannot indefinitely distribute more than the total return generated by its portfolio without eventually eroding its capital.Ā
This is where much of the criticism of income investing comes from. The belief that someone who has not saved enough for retirement can use high-yield investments to make up the shortfall. This is not an argument that income investing does not work, it clearly does, and plenty of investors have been successful using income strategies for years.Ā It is an argument that the underlying savings requirement does not magically shrink just because the yield is higher.
Growth and income strategies are often trying to accomplish a similar goal: converting accumulated capital into cash flow an investor can live on. A growth investor generates cash flow by receiving modest dividends and periodically selling shares. An income investor receives larger distributions directly. But regardless of the mechanism, the cash flow a portfolio can sustainably produce still depends on the capital deployed and the total returns that capital generates.
One of the appeals of income investing is that the investor may never personally press the sell button. But that does not mean selling is not happening.
A covered call fund may collect dividends and option premiums, sell portfolio assets, close or roll option positions, realize gains and losses or, when physically settled calls are used, have shares called away through assignment. The investor may not be the one pressing the sell button, but the portfolio still has to generate or release enough value to support the cash being paid out.Ā
This is especially important with covered call funds because the strategy has a structural asymmetry: the option premium provides only limited protection when markets decline, while the calls can cap part of the portfolioās upside when markets rise. This is one reason many income investors diversify across different types of funds and income sources rather than relying entirely on equity-based covered call strategies.
Some people might promote the idea that you could invest a much smaller amount of money, say $200,000 in a covered call fund, collect approximately $5,000 per month and enjoy the same income as someone who saved $1 million. What they often leave out is that part of the distribution may need to be reinvested. Why?
Over time, the portfolio must generate enough total return to support withdrawals, fees and the desired degree of inflation protection. Otherwise, the investor will gradually consume capital. That may be acceptable when it is intentional and built into the retirement plan, but it is dangerous when the investor believes the entire distribution can be spent indefinitely.Ā
A 30% yield may look attractive, but if the fundās NAV continues to decline, the income it produces may eventually decline as well. If the distribution is based on a percentage of the fundās value, a smaller asset base produces a smaller payment. Even when the distribution remains fixed, maintaining it may require the fund to consume more of its remaining capital.
It does not matter whether you use a growth portfolio or an income portfolio. If your portfolio generates a total return of $60,000 for the year and you withdraw $70,000, the additional $10,000 has to come from somewhere. You are spending down your capital.
A growth investor may make that decision directly by selling more shares. An income investor may pay a portfolio manager to make a similar decision on their behalf.
With income investing, the decline can be harder to recognize because the investor is not personally selling anything. The fund handles the mechanics behind the scenes while the investor simply sees cash arriving in the account. That can create the illusion that the entire distribution is income, even when some of it may be coming from realized gains, asset sales or a return of the investorās own capital (ROC).
Outside of tax-sheltered accounts, this creates a hidden drag. While ROC isn't taxed immediately, it reduces your adjusted cost base (ACB), creating a looming tax liability that will trigger larger capital gains when you eventually sell the fund. With standard growth strategies the investor controls when to sell assets and realize taxes, whereas high-yield funds force taxable distributions onto your lap.
That is the greatest lie in income investing: the belief that a high distribution rate can replace the need to save sufficient capital or generate adequate total returns. It cannot. A 30% distribution is not the same thing as a 30% return.
The distribution tells you how much cash is being paid out. Total return tells you whether the portfolio actually earned that money.
Income investing can be a useful way to structure cash flow. It can reduce the need to sell shares personally, make retirement income easier to manage and provide a more predictable stream of cash.
But it does not change the underlying mathematics. Whether you sell shares yourself or the fund handles the selling behind the scenes, the portfolio still has to generate enough total return to support what you withdraw. Otherwise, eventually, the money runs out.
