The passive way to generate cashflow

This article is part of
Exchange traded funds - November 2014

Income is by far the most popular buzzword in the investment world at the moment, and with it come the usual suspects in terms of product offerings such as UK Equity Income, US Equity Income or various bond strategies and fixed income alternatives.

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.

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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.