THE WINTER IS COMING, JON SNOW
THE STORY OF DIVIDEND INCOME FUNDS
Bennie Gerber – Compliance Officer
Megan Fraser – Head: BD & Marketing
While most market commentators and investors love to tell or be told fascinating tales of great losses and gains made by investing in equities, there is a component of the investment storyline that is often sorely neglected. I would suggest that this is the Jon Snow* of the investment landscape – understated, excluded and disregarded despite being honourable, reliable and authentic. The investment option I refer to is cash.
Generally speaking, there are two types of investors who elect to invest in cash.
The first is the conservative investor who simply wants liquidity, certainty and capital security. They may be older and closer to retirement or are already retired and are willing to sacrifice potential return for peace of mind. These investors usually have little or no debt and love rising interest rates as their “safe investments” give increased returns. Given current market uncertainty it is easy to understand why these investors might choose dependable cash returns over the potential of volatile equity returns.
The other type of cash investor is one who is looking for a short- to medium-term ‘parking place’. These investors are likely to have an outlook in the region of 6 to 18 months. The ‘parking’ might be while they wait to move their funds back to more aggressive strategies or it may be a seasonal or cyclical reason. This parking zone should ideally offer the certainty, security and liquidity of a bank deposit type investment, but with a competitive yield and, if at all possible, tax efficiency.
There are a myriad options in the cash/conservative space but for this article we’ve focused on four broad options that are easily accessible in the retail segment.
Income and Bond Funds
Money Market funds
Dividend Income Funds
Call accounts have paramount liquidity but also the lowest yield and, contrary to popular belief, they have higher risk than money market funds as they are exposed to only one issuer. This is also a fully taxable return (after the allowable tax exemption).
Income funds can often have a high bond exposure and this can cause fluctuations in the fund value which can be a little unnerving for the truly cautious. Another reason for caution is that very often the bond market struggles when equity markets struggle. Add to this the pending rating agency downgrades and one has to ask if income and high income funds can maintain the heady returns that investors have become used to. We would simply say that winter is coming and we need to be prepared.
That leaves us with money market funds and dividend income funds. What might be considered the critical differentiator between these two types of funds is the manner in which tax is treated. The returns received by money market funds, as with call accounts, are fully taxable interest (with some allowable tax exemption) whereas the tax incurred by dividends is treated quite differently, usually a more forgiving treatment.
The table below compares the net yield of a dividend income fund to that of a money market fund and shows the pronounced effect on a corporate investor or a high net worth individual or any investor in a 45% tax bracket.
As you can see, a dividend fund yield equates to a pre-tax return of 9.50% for individual investors and 9.07% for companies.
It is important to note, however, that not all dividend income funds are created equal – some dividend income funds include an element of interest in their yield; the higher the proportion of dividend, the more tax efficient the yield.
In a nutshell, dividend income funds are liquid, secure investments that provide an attractive after-tax yield when compared with money market funds. They are a great option if you are looking for a parking place for cash or if you are a conservative investor by nature. Why pay more tax than you need to if you could rather bank it for the coming winter?
Jon Snow is a fictional character in the ‘A Song of Ice and Fire’ series of fantasy novels by American author George R. R. Martin, and its television adaptation Game of Thrones. "Winter Is Coming" is the motto of House Stark, one of the Great Houses of Westeros. The meaning behind these words is one of warning and constant vigilance. Jon Snow remarks that his father, Eddard Stark, was bound to be right eventually. ~ Wikipedia