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How to generate income with low-cost ETFs

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You've got $50,000 to invest, with a focus on generating income. What to do?

Before answering that question, let's make a few assumptions about what you don't want. First, you probably don't want to wake up one morning and find that your $50,000 has become $30,000 overnight. As an income investor, you need security and reliability of returns. That has implications for where you invest.

Second, you don't want transaction costs to eat away at your returns. Investors generally trade too much and pay a price for it, not just in lower returns but higher transaction costs. You want to minimise those costs while maximising potential returns, without too much risk.

How to generate income with low-cost ETFs

Third, you want more than the returns available on term deposits.

Now don't me wrong here. Term deposits are about as low a risk investment as we can get.

Here in Australia returns may only be 2.5% or so and in places such as Europe, America and Japan they are effectively zero. The problem is that the returns, even if you don't spend the income, are barely keeping pace with inflation.

So beating inflation requires a step up the risk curve but you don't want to take too big a step and trip yourself up. In the back of your mind is that possibility of waking up from an afternoon nap and finding your portfolio is worth 20% less than when you put your head down. Term deposits are fine if your first priority is low risk.

Keep up with inflation

So how can you generate more income, accepting you have to take more risk? You can build an income portfolio using low-cost exchange traded funds (ETFs) yourself but a simple option is to use an InvestSmart income portfolio.

Before we go any further, I do want you to know that I am chairman and a shareholder in AWI, which owns 100% of InvestSmart and Intelligent Investor.

The income portfolio steps lightly towards growth assets, using ETFs to keep costs to a minimum but achieving a high level of diversity. The chart shows the portfolio's components.

So what exactly does "stepping lightly towards growth assets" mean? Well, at present about 57% of the portfolio is invested in fixed interest, such as bonds, and 4% in cash. This is the traditional income-investing strategy, a defence against the prospect of capital loss but with a twist.

That defensive allocation is secured through an investment in the iShares Composite Bond ETF, a managed fund with a core holding in Australian corporate credit and the ability to include some global investments where a higher yield can be obtained, and the BetaShares Australian High Interest Cash ETF. So we're getting a higher yield by investing in corporate rather than government debt.

Including the 4% allocation to cash, this portion of the portfolio is projected to yield about 3.1%, better than what one can expect from cash and Australian government bonds.

But what about a bit of growth to keep pace with inflation? Well, about 25% of the this income portfolio is invested in Australian shares, via the iShares S&P/ASX 200 ETF, for low-cost access to the largest 200 listed Australian companies.

This investment is expected to yield around 5.2%. There are some good fundamental reasons to include a modest weighting to local shares: they pay generous dividends and company tax on profits is credited towards an individual's tax liability (known as "franking credits").

This is terrific for low-tax payers and super funds. Our expectation of income returns from the Australian listed property allocation of 12% is also good, at about 5.1%. Here we're using the Vanguard Australian Property Securities ETF, which tracks the S&P/ASX 300 real estate investment trust index.

Focus on the long term

Of course, there's a trade-off. Holding listed investments such as Australian equities and real estate trusts should deliver a superior yield but also means you'll have to live with capital values bouncing around, as they have over the past few months.

But the fixed-interest allocation means your portfolio won't be as volatile as the overall market. It's a good way to get a higher return and a good night's sleep. The key is to focus on the long-term returns and not get hung up on short-term volatility.

Minimal fees are also critical. Fees are a drag on returns and low-cost ETFs are a neat solution to the problem. Even a small difference in fees over the long term compounds into a significant difference in savings.

For the 12 months to December 31 last year, the InvestSMART income portfolio returned 4.33% income, clearing the benchmark hurdle of CPI plus 1%.

For a $50,000 portfolio, that equates to an income of $2165. In a difficult year for the sharemarket, the conservative nature of the portfolio shone through as a $50,000 investment was valued at $49,841 on January 1. In a "normal" year, if we ever get such a thing, the portfolio with its modest exposure to shares would show modest growth in value, as well as income in excess of 4%.

Paul Clitheroe is chairman of the Australian government's Financial Literacy Board and a best-selling author. He is also chairman and a shareholder in AWI, which owns 100% of InvestSMART and Intelligent Investor.

How to adapt it

How should a well-diversified portfolio be adapted for smaller amounts? If you're using a few ETFs to hold many times more assets, not that much.

The InvestSMART income portfolio consists of just six holdings. But the four ETFs hold more than 550 investments. The bond ETF alone holds about 330 instruments to track the Bloomberg Australian Composite Bond Index.

The advantage of using index ETFs is that one transaction usually delivers access to all constituents of the benchmark the fund aims to replicate, although in some cases an ETF may not hold all the stocks in a benchmark.

This means that three portfolios of, say, $100,000, $50,000 and $10,000 will be similarly diversified.

There is, however, an additional cost for the self-directed investor because the smaller the portfolio, the higher the transaction costs of buying the ETFs as a proportion of the total amount invested. With a managed portfolio such as our income portfolio, however, transaction costs are substantially lower than they are for individuals making their own trades.

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Paul Clitheroe AM is a respected financial adviser and Money's founder and editorial adviser. He is chair of the Australian Government Financial Literacy Board, and author of several personal finance books. Click here to email Paul your money question. Unfortunately Paul cannot respond to questions posted in the comments section.
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