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Why it is smart to look to passives to enhance income

A multi-asset portfolio is by its very nature diversified, and that freedom to invest across asset classes, regions, sectors and styles, also allows for both active and passive strategies to be used as building blocks of a portfolio to help meet your income needs

In recent years the variety of passive strategies, including exchange-traded funds (ETFs) and index tracker funds, has increased significantly including the rise of enhanced passive strategies, sometimes referred to as ‘Smart Beta’.

Some of these ‘Smart Beta’, strategies are specifically tilted towards an income focus, which means it gives you some of the benefits of an actively managed portfolio with an income tilt but at a more cost-effective price point.

Looking underneath the bonnet

It’s important to note, however, that it’s not just as simple as buying an ETF called “US Equity Income ETF” and thinking that’s job done. In reality, the underlying indices that these vehicles are tracking can all be constructed in very different ways.

Investors, therefore, need to do the work to make sure they understand the intricacies of each of these ETFs so they appreciate any sector biases, country biases or stock specific risks that they may have because of the index methodology.

If you think about allocating to US or UK equities, and you choose a high dividend yield ETF, it is likely that while the vehicle might contain many of the stocks that sit in the broad index (S&P 500 or FTSE 100), it won’t contain all of them and their weightings may be substantially different. This means the ETF could behave very differently in certain market environments compared with the regular index.

For example, if you’re picking out stocks with a high dividend pay-out ratio, you’ll likely end up tilted towards utilities and energy. In the mid-2000s, equity income portfolios were typically tilted towards banks, which particularly caught out income investors when they cut or suspended their dividends during the financial crisis of 2008/9.

Choosing the right strategy

That said, there are reasons why a passive income strategy might be the better choice for a portfolio than an active fund, such as cost, types of exposure and accessibility to a market.

Ease and nimbleness are also key factors to take into consideration.

In particular, from the point of view of being able to move quickly in and out of positions, using ETFs may be preferable to active strategies, which on the whole can only be traded once a day.

Because ETFs trade whenever the market is open, like a regular share, you can make these switches whenever you see an opportunity. In the current environment, for example, if say President Trump announced a trade deal with China in the afternoon UK time, which creates an opportunity, then you can do something there and then. From a practical sense, it gives you a little bit more control.

Active certainly has a place

Investors must bear in mind, though, that index construction for income tilted passives is, almost by definition, typically focused on historic metrics rather than forward looking predictions. Examples are screening for stocks with the highest dividend yield or stocks that have a track record of dividend growth over a defined period.