While dividends are expected to play an increasingly important part of total returns in the expected low economic growth environment going forward, investors need to be aware of the yield trap, according to Insync Funds Management.
"There is a difference between looking for companies with high yields and looking for growing, dividend-paying companies," the firm's chief investment officer Monik Kotecha said.
"A lot of investors just look for high income stocks and look for high yield stocks and they think 'that's terrific'.
"Well, clearly what the last few years have shown us is that a lot of these stocks have actually ended up being a yield trap because they were tested by the economic crisis."
Companies that have large dividends tend to have high payout ratios, Kotecha said, meaning they dispersed most of their profits and left little to grow the business.
"If you are generating $100 in profits, for example, and you know if you are paying most of those profits in dividends, there is very little left behind to help grow the business," he said.
"That's fine as long as business conditions are fine, but as economic conditions have changed significantly, those profits have come under pressure and so their dividends have collapsed and typically the share prices have also collapsed quite significantly."
Insync, which manages the Global Dividend Growth Fund, seeks companies that have a more modest payout ratio of about 40-50 per cent, Kotecha said.
"If you are retaining earnings you are compounding what you are leaving behind in the business at a very high rate and that helps lift earnings growth, and if you lift earnings, then you have the capacity for consistent dividend growth," he said.
"Our research shows that rising dividends and growth in capital go hand-in-hand and are both a critical part of the return equation."
Insync was established in 2009 by Kotecha and Garry Wyatt.
Kotecha previously worked as a senior portfolio manager of the Australian Share Fund at Investors Mutual and was with the firm for seven years.
