The old adage: “If it sounds too good to be true, it probably isn’t” is not always correct, but when it comes to investing, it seems to be right more often than it’s wrong. Certainly, it should scream “CAUTION” to a potential investor. Not necessarily a red flag, but a strong push to do your homework.

Over the last several months, I have been inundated with offers promising “high” income returns from investing in international shares, and even higher income returns from investing in Australian shares. I have to declare at the outset that I am immediately “suspicious” of these offers, because income from shares (dividends) is more like 4% in Australia and 2% overseas. Here is a chart from the Reserve Bank that shows the long-term picture.

While skilled fund managers can generate a higher yield through a combination of stock selection and portfolio construction, and various techniques can be applied to “capture” income, the chart above suggests that a manager promising an “over the top yield” yield, without a commensurate statement about the higher risk, should be scrutinised carefully. Capturing techniques, such as buying a stock “cum” dividend and selling it “ex” dividend, or writing out of the money call options on stocks, in return for receipt of premium income, while legitimate, also entail higher risk.

But sometimes it is the promotion, rather than the investment structure, that deserves scrutiny. Let’s take a recent example to demonstrate.

BetaShares Legg Mason Equity Income Fund (managed fund)

BetaShares is one of Australia’s leading providers of Exchange Traded Funds (ETFs) and Legg Mason is one of the world’s largest investment groups. Legg Mason’s Australian affiliate, Martin Currie Australia, will be the investment manager of the fund. The fund is an actively managed investment fund that trades on the ASX under stock code EINC.

Its investment objective is to provide an after-tax income yield above that of the S&P/ASX 200 index by investing in a portfolio of listed Australian equities, and aims to grow this income over the rate of inflation over the long term.

To do this, the investment manager works on the premise that high-quality companies that have solid earnings can sustain dividends, match rises in the cost of living and are likely to be less volatile than the wider equity market. The fund is managed in a tax-aware manner in order to benefit from franking credits, and operates within the following parameters:

• Exposure to an individual stock is no more than 6% of the fund;
• Approximately 40 securities are held;
• Exposure to an individual sector (as determined by Martin Currie Australia) is no more than 22%;
• It is a long-only fund, with a maximum cash holding of 10%; and
• Exposure through derivatives is restricted to managing temporary mismatches (no short selling, leverage or gearing).

The management fee is 0.85%, plus an estimated 0.04% for net transactional and operational costs.

So far so good.

But what caught my eye was this promotional claim that leapt out of the page: “7.0% *”. The immediate fine print below said “ *Next 12 months forecast franked yield (gross) as at 31 January 2018”.

Interestingly, this claim wasn’t in the Product Disclosure Statement (PDS), dated 5 February 2018, but rather in a flyer available on the BetaShares website. I say interesting, because it is the PDS that investors are supposed to refer to before making an investment.

Let’s unpick the claim.

Firstly, the yield is “grossed up” for the benefits of the dividend imputation system and is expressed on an equivalent “pre-tax” basis to those investments that don’t have franking credits, such as investments in property, fixed interest or term deposits. It assumes that all investors will get the full benefit of the dividend imputation system, and while this is true for investors paying tax at 47% or 39%, it may not be true for investors (including self-managed super funds) paying tax at rates of 30% or below:

• If Bill Shorten gets elected and implements his policy to stop the refunding of excess imputation credits, many self-managed super funds and other low rate taxpayers not in receipt of a government pension (eg, a non-working spouse) won’t be able to access the full benefit of the gross-up; and
• Where imputation credits are refunded, it can often take up to 18 months from the time of receipt of the dividend before the cash refund from the ATO is received.

Next, the claim refers the “portfolio’s return” and excludes the fund’s fees and expenses. As an investor, your distributions are calculated after the manager takes their fee, which in this case is around 0.85%.

The S&P/ASX 200 weighted averaged dividend yield is around 4.3%, franked to just under 80%. Grossed up, this takes it to a little shy of 5.8%. The BetaShares Legg Mason Equity Income Fund can probably do a bit better than this, but there is still the management fee to come out. And, if you can’t access the full benefits of the dividend imputation system, the return is going to be quite a bit less.

One thing that is almost certain – investors won’t be receiving a cash distribution of 7% pa.

If it is too good to be true…

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.