Magellan Financial Group has been making headlines over the past few months, starting with the departure of its chief executive officer, losing its largest institutional mandate, and more recently with its high-profile co-founder, chairman, and chief investment officer stepping away indefinitely for medical leave. The share price subsequently crashed to $18.11 as of 11 Feb 2022, down from its high of $65.36 in August 2020. The 72% decrease wiped more than $8.5 billion off its market capitalization.

A variety of Australia-domiciled funds (both listed and unlisted) were invested in Magellan Financial Group (ASX: MFG) over this period, but among the most noticeable were yield-focused strategic-beta exchanged-traded funds. Of these ETFs, VanEck Morningstar Australian Moat Income ETF (ASX: DVDY), SPDR MSCI Australia Select High Dividend Yield ETF (ASX: SYI), and ETFS S&P/ASX 300 High Yield Plus ETF (ASX: ZYAU) had the largest holdings at the data reporting date of 11 Feb 2022. Strategic-beta ETFs typically select investments according to a rules-based system.

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Yield-focused funds can be susceptible to dividend-yield traps

These yield-orientated funds screen and select stocks using dividend yield as the core metric—a backward-looking approach. This type of strategy can lead to what's known as a dividend-yield trap, which occurs when investing in a company that has a high relative dividend yield but also flawed fundamentals. This lack of quality can in turn lead to a share price drop, offsetting the income return received from the dividend. Any future dividend cuts will result in lower income than originally anticipated.

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Magellan Financial Group's falling share price since mid-2021 has led to its dividend yield rising above most companies' dividend yields in the S&P/ASX 200 Index. This relatively high dividend yield has seen it feature in many Australian yield-focused equity funds. Magellan Financial Group paid an $2.11 per share dividend in the 2021 calendar year, resulting in a dividend yield of around 10%, making it the fifth largest dividend-yielding company in the index as of 31 Dec 2021. Fortescue Metals Group (ASX: FMG), Rio Tinto (ASX: RIO), Waypoint REIT (ASX: WPR), and AGL Energy (ASX: AGL) were the only companies that had a higher dividend yield (from largest to smallest).

Passive or rules-based funds can naively invest in stocks based solely on dividend-yield metrics with minimal other research being conducted. Many were caught by the quick reversal of fortunes at Magellan, though some of these funds have measures in place to safeguard against this pitfall, such as considering dividend stability.

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Be aware of the risks

As interest rates around the world persist at all-time lows, advisers and investors have turned to higher yielding funds that aim to pay regular dividends as sources of income, but this comes with risks. Advisers and investors seeking income away from bonds should be aware that looking at the aggregate dividend yield for a fund (or stock for that matter) in isolation is not an effective measure to determine its investment merit, especially when those strategies are constructed based on simple dividend screens. We strongly suggest only using these yield-seeking, strategic-beta funds as supporting players within investment portfolios and not as a fixed-income substitute. A supporting player should not constitute more than one third of an investor's exposure within one particular asset class.