Enhanced income passive vehicles might all sound the same, but underneath the bonnet they can be very different. Quilter Investors’ CJ Cowan explains why investors need to understand exactly what they’re putting into their portfolios.
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.
These sorts of biases happen because particular sectors are known for paying out high dividends, so there can be a tendency to over allocate to them if you have an undue focus on yield.
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. And 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
It is interesting how some of the mainstream ETF providers have looked to neutralise some of these biases. This can include trying to balance the need to focus on income producing stocks while maintaining diversification across sectors so that overall the vehicle behaves more in line with the broader market whilst still retaining the thematic tilt towards income.
That said, there are numerous 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, however, are also key factors to take into consideration.