Bloomberg recently reported that dividends have become "the new hot thing" among Gen Z retail investors, with a growing group using and promoting them as a ticket to early retirement [1].
Must Read
- Thanks to Jeff Bezos, you can now become a landlord for as little as $100 — and no, you don’t have to deal with tenants or fix freezers. Here’s how
- I’m 49 years old and have nothing saved for retirement — what should I do? Don’t panic. Here are 6 of the easiest ways you can catch up (and fast)
- Dave Ramsey warns nearly 50% of Americans are making 1 big Social Security mistake — here’s what it is and 3 simple steps to fix it ASAP
The report compares this “quasi-religious investing movement” to others that have sprung up in response to the economic hardships facing younger generations in America, including the struggle to afford housing and the prospect of AI taking their jobs. Many young people appear to be disillusioned with the traditional model of working a 9-to-5 job and putting away retirement savings for most of your life.
“The dividend finfluencers see themselves as the sober cousins to the YOLO crew, closer in spirit to the FIRE movement, with its focus on financial independence and retiring early,” says Bloomberg.
But they’re not just buying shares of decades-old companies with strong dividend histories. Instead, they’re putting money into ETFs that use complicated derivative formulas to pay out larger dividends. And this, experts say, reduces their potential for long-term returns.
Derivative-based ETFs are gaining popularity
Chasing dividends is an investment strategy that many people use to meet their financial goals. Here’s how it normally works: Buy shares of quality, established businesses with a long history of paying and raising dividends. Hold those shares for many years. Collect dividends along the way, spend or reinvest them, and eventually retire on not just the wealth you’ve accumulated in your portfolio, but the ongoing income those dividends provide.
But while investing in dividend-paying stocks or dividend ETFs (exchange-traded funds) is a fairly tried and true strategy, now, investors are taking that concept to a new level with a another type of ETF “offering eye-popping yields generated by complex derivatives.”
Bloomberg reports that these aggressive ETFs boasting yields upward of 8% have quadrupled in size in just three years to about $160 billion.
It’s a strategy you may be interested in, too. But it’s important to understand the pros and cons.
How derivative-based ETFs work — and why they can be dangerous
Traditional dividend ETFs invest in companies with strong dividend histories. Derivative-based high-yield dividend ETFs create income based on options contracts — a much riskier endeavor.
A common strategy seen in these ETFs is the covered call. The ETF will hold stocks it sells call options on. A call option gives a buyer the option to buy a stock at a set price by a certain date. In exchange for that right, the buyer pays a premium into the ETF. The ETF then shares those premiums with shareholders in the form of high-yield dividends. The upside, of course, is stronger returns and income you can cash out or reinvest to grow your portfolio. But these ETFs carry risks that traditional ETFs do not.
Read more: Robert Kiyosaki warns of a ‘Greater Depression’ coming to the US — with millions of Americans going poor. But he says these 2 ‘easy-money’ assets will bring in ‘great wealth’. How to get in now
By selling covered calls, a derivative-based ETF inherently caps its potential gains. If the stocks it’s selling calls on gains value, the ETF will have to sell at the lower option price its contracts call for, missing out on gains. Remember, quality stocks, historically speaking, have a tendency to gain value over time. This doesn’t mean they don’t lose value from time to time. But over a decades-long period, a good stock is likely to gain value overall. These derivative-based ETFs can miss out on those gains. And as an investor, so will you.
“So, over long-term periods where you’d expect stocks to have a positive return, these funds are probably going to trail the total returns of something simple like the S&P 500,” said Jason Kephart, a senior principal with Morningstar’s multi-strategy asset ratings team [2]. “So, that’s the main thing I would think is the risk you should be aware of heading in because that’s the one that’s most likely going to play out.”
Bloomberg also warns that these new ETFs come with a higher tax burden since “derivatives-based payouts don’t get the preferential treatment of qualified dividends and are instead taxed at ordinary income rates.”
One of the most popular derivative-based income ETF is the JPMorgan Equity Premium Income ETF.
A good approach to chasing dividends
You may want to be careful with these mega-yield ETFs, despite the larger yields they may generate at times.
Remember, a big way to grow your nest egg is to have the value of your investments rise over time. Derivative-based ETFs have limited growth potential, so they may stunt your portfolio’s growth, too. That could make it a lot harder to retire early — or retire comfortably at a more traditional age.
This isn’t to say that you should not invest in these ETFs at all. To make that determination, it’s best to consult with a financial advisor and consider factors like your income goals and risk tolerance.
But if you’re going to invest in derivative-based ETFs, you may want to limit them to a portion of your portfolio and put the rest of your money into other assets that include traditional dividend stocks, growth stocks, and broad market/S&P 500 ETFs. Focus on building a well diversified portfolio that can still produce a lot of income but offer less risk and more potential upside with a suitable asset allocation. This means including stocks and ETFs that don’t provide dividends because they offer other benefits like growth and value.
You’ll also want to keep in mind how you’ll be taxed for owning dividend ETFs and management fees you will be paying.
Remember, too, that living on investment income, as opposed to a paycheck from a job, hinges on having a large enough amount of money to invest in the first place – regardless of the assets you choose. A $100,000 portfolio that generates an 8% return, which some of these aggressive ETFs may do, produces $8,000 a year of income. A $1 million portfolio produces $80,000.
What to read next
- How much cash do you plan to keep on hand after you retire? Here are 3 of the biggest reasons you’ll need a substantial stash of savings in retirement
- There’s still a 35% chance of a recession hitting the American economy this year — protect your retirement savings with these 5 essential money moves ASAP
- This tiny hot Costco item has skyrocketed 74% in price in under 2 years — but now the retail giant is restricting purchase. Here’s how to buy the coveted asset in bulk
- Want an extra $1,300,000 when you retire? Dave Ramsey says this 7-step plan ‘works every single time’ to kill debt, get rich in America — and that ‘anyone’ can do it
Join 200,000+ readers and get Moneywise’s best stories and exclusive interviews first — clear insights curated and delivered weekly. Subscribe now.
Article sources
At Moneywise, we consider it our responsibility to produce accurate and trustworthy content people can rely on to inform their financial decisions. We rely on vetted sources such as government data, financial records and expert interviews and highlight credible third-party reporting when appropriate.
We are committed to transparency and accountability, correcting errors openly and adhering to the best practices of the journalism industry. For more details, see our editorial ethics and guidelines.
[1]. Bloomberg. "The New American Hustle: Dividends Over Day Jobs"
[2]. Morningstar. "Ask Your Advisor These Questions Before Investing in Derivative Income ETFs"
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.