Ways to generate an income with ETFs

This article is part of
Passive Investing - November 2015

Income-focused investors face a more complex world in 2015 than during recent decades.

Bonds have traditionally been the asset class of choice for investors seeking a reliable income stream. But recently, yields on short maturity bonds in many major government debt markets have moved into negative territory, meaning investors are effectively paying to own the debt.

During the first quarter of 2015 negative yields were recorded on short-maturity government bonds in Belgium, France, Germany, the Netherlands, Sweden, Switzerland and Japan.

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Most fixed income yields are at, or near, historic lows in many markets. For example, in the US the yield on 10-year government bonds at the end of 2014, at 2.2 per cent, was close to its all-time low, and 53 per cent below the average US long bond yield between 1871 and 2014, which was 4.6 per cent.

Equity dividend yields are also at, or near, historic lows. At the end of last year the yield on the S&P Composite, a broad index of US equities, was 2.2 per cent, which is 52 per cent below the average US equity market yield between 1871 and 2014 of 4.5 per cent.

Given the harsh yield reality, investors could opt to build income-oriented portfolios using exchange-traded funds (ETFs). It may come as a surprise how many options are available.

ETFs on high-dividend equity indices

By design, high-dividend equity indices aim to produce a higher income stream than indices tracking broad equity indices. High-dividend indices’ rules typically comprise a number of eligibility requirements for constituents, such as a positive past record of dividend payments and additional quality screens to help ensure dividend sustainability.

For example, the Euro Stoxx Select Dividend 30 index only chooses companies with a positive or neutral historical five-year dividend-per-share growth rate and a defined dividend-to-earnings-per-share ratio. Another example is the MSCI North America High Dividend Yield index, which, as well as requiring a track record of consistent dividend payments, also screens for certain quality factors, such as return on equity.

These types of high-dividend methodologies can outperform the yields of their representative benchmark indices. For example, as at the end of June this year, four high-dividend indices – Stoxx Global Select Dividend 100, Euro Stoxx Select Dividend 30, MSCI North America High Dividend and MSCI AC Asia ex Japan High Dividend – offered an average gross dividend yield increase of 64 per cent compared with their respective benchmark indices.

ETFs on higher yielding bond indices

When it comes to bond investing, there are ETFs on higher yielding bond indices where the higher return is acquired through the index tracking a portfolio of higher risk bonds relative to, say, UK gilts. For example, there are ETFs that provide exposure to emerging market sovereign bond indices and ETFs that track high-yield corporate bond indices.

ETFs on Reit and infrastructure indices

Real estate investment trusts (Reits) are listed companies that own or finance income-producing real estate. Reits operate under a legal framework that typically requires them to distribute the majority (often 90 per cent) of their net income to shareholders, which means dividends make up a higher proportion of the total returns from Reits than is the case with equities generally. These legal requirements make Reits natural portfolio holdings for income-focused investors.