The passive way to generate cashflow

But a potentially overlooked area and source of income is the exchange-traded fund approach. With more than 20 ETFs listed on FE Analytics with ‘income’ in the name, it seems investors also have plenty of choice.

The question is whether income from a passive vehicle is really worth it.

Arne Noack, head of exchange-traded product development, EMEA at Deutsche Asset Wealth & Management, says that the current difficulty for investors is that no asset class is providing decent returns on their own, interest rates remain at historically low levels and even gold, which is usually seen as a safe haven, has seen its price dip.

He adds: “With some predicting continued secular stagnation in the world’s economies, investors might look to income-generating types of investments, such as higher dividend-paying stocks, for at least some element of performance. ETFs provide investors with a straightforward route to acquiring income-oriented investments.”

Mr Noack points out the investors looking for yield can use ETFs to gain exposure to dividend-weighted equity indices and to specific equity sectors characterised as being defensive, such as utilities.

“Taking exposure to the higher-yield areas of the fixed income market is another strategy,” he says. “Regular fixed income exposures, which can also be acquired via ETFs, could attract income-seeking investors again if interest rates rise.”

Howie Li, co-head of Canvas, an ETF-based solution at ETF Securities, agrees that in theory holding an ETF portfolio for income generation is absolutely possible, and in the future it is probable that more ETFs will distribute dividends, providing there is a continued demand for yield.

He adds: “I think this theme will continue, especially with the new UK pension changes coming in April, where pensioners can take more control of their pension pot to invest individually and most will require some element of regular income in order to maintain their lifestyle.”

However, he explains that in any ETF, the dividend payout will be driven by the dividend profile of the underlying stocks or bonds. Therefore it is important to be aware that while some ETF exposures are better suited for income generation, such as high dividend large caps, others are more geared towards dividend accumulation, such as growth sectors and small caps.

“I envisage that investment advisers will use a combination of income-distributing and dividend-accumulating ETFs to create the right blend of growth versus yield for their clients’ needs. However, investment advisers and investors should be aware of any costs associated with manually re-investing yields when compared to allowing the efficiencies built within an accumulating ETF itself to serve the same purpose,” cautions Mr Li.

Income generation, while a key focus for many, especially at certain periods in their life, should not be the only consideration when looking at building a portfolio.

Peter Westaway, head of Vanguard’s investment strategy group in Europe, says: “One needs to be very careful not to lose sight of the fact that the most important property of any investment is its total return and simply skewing your focus towards those investments that generate a particular return, rather than a split between capital gain and income, you may end up giving up overall return.

“Investors should be careful not to be obsessed with income at the expense of overall return.”

That said, he points out that one of the advantages of using ETFs and passive vehicles to build an income portfolio is the normally lower costs involved. In particular he points to research that suggests funds with lower charges tend to perform better on average than those with higher charges, as by charging higher fees, even the so-called ‘star’ active managers handicap themselves when it comes to outperforming.

Mr Westaway adds: “That’s the beauty of the passive approach. You’re not having to pay a star fund manager, there is typically lower transaction costs with a passive fund, and so all of those things tend to lessen the overall cost drag that will be associated with it. That is a very good place to start.”

Nyree Stewart is features editor at Investment Adviser

Expert view

Andrew Walsh, head of UBS ETF sales, UK and Ireland

Investments which deliver strong income can offer investors an interesting mix of potential returns and stability. In particular, this applies to equities delivering high dividend yields. This is due to the fact that while prices in the equity market can often fluctuate quite strongly, dividend payments mostly remain relatively stable – even during bear markets. The significance of dividends is correspondingly large for long-term investment success.

ETFs offer investors an intelligent and efficient access to dividend strategies, be it via an ETF tracking the Dow Jones Global Select Dividend index or via an ETF which specifically invests in defensive sectors of the economy.

An important aspect to consider when investing to access income in the equity space is, of course, the impact of dividend compounding. If one was to look at the price return (excluding dividends) of the MSCI World index from 1975 to 2014, the index returned approximately 18x over that period. If one includes the dividends paid out by the MSCI World and reinvested those back into the index consistently, the total return over that period would have been roughly 39x.

However, things get very interesting when choosing a high dividend yielding global index and coupling that with the effect of dividend compounding, using as an example the MSCI World High Dividend Yield net total return index. From 1975 to 2014, that index has delivered total returns of 70x, due to the positive impact of combining a high-yield equity-screening process with the positive impact of dividend compounding.

While there are a handful of different dividend-focused global equity indices to choose from, the most attractive is the DJ Global Select Dividend index. With an average 10-year yield of 5.06 per cent and the most rigorous dividend yield screening process for its global equity constituents, it presents a very interesting opportunity in this current yield-deprived investment environment.”