Enhancing your income through passives

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.

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 are structured as pooled vehicles that only price once a day.

This means if the fund prices at midday and you want to buy or sell at 1pm, you have to wait until the next day before you can trade. Whereas 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

One thing to note though is 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.

Active managers of income strategies will regularly have an allocation to “turn- around” stories, perhaps where they expect a company that has no history of paying dividends to start paying one.

Companies like this will generally not be captured by the index rules of an income tilted passive fund so opportunities may be missed, highlighting one of the many benefits of active management.

Creating the right mix

Investors should also not ignore the benefits of standard index trackers and their place in a fully diversified portfolio. These could be particularly useful in the wake of a global macro event, as it may be slightly clearer how the broader market indices might respond.

Furthermore, the UK equity market, historically, has a high dividend pay-out ratio and so income investors get a better yield from UK stocks generally. For that reason, just holding a FTSE tracker could generate much of the income you would need from a UK allocation.

Therefore, the savvy investor is likely to have a combination of active strategies, Smart Beta ETFs and traditional trackers. But investors have to be aware of whether the ETF or passive strategy they are using actually has all the exposure they are looking for and ensure that they understand any underlying biases that might affect their portfolio and the returns it can deliver.

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