Income investing for beginners: managed funds vs. ETFs
Play it smart and your investments can provide extra money to live on
Investing doesn't have to be about waiting for capital growth. Investments that generate regular income can be useful in a variety of situations, from supporting a small business in the start-up phase to paying for your children's education, or funding a retirement lifestyle.
The challenge in today's low interest rate environment is that cash-based investments like savings accounts and term deposits, will dish up a meagre income. Time to look elsewhere.
Andrew Dunbar, director at advisory firm APT Wealth Partners, says there are a number of options for income investors. These can include fixed interest investments or shares that deliver healthy dividends. Alternatively, he says investors can take the indirect option of managed funds or exchange traded funds (ETFs).
Here's what to weigh up.
At the lower end of the risk spectrum, fixed interest investments typically include government or corporate bonds that work like a loan from you to the bond issuer. The bond has a fixed lifespan during which bondholders receive a set rate of interest based on the face value of the bond (the coupon rate), with the full amount of the bond paid back on maturity.
Exchange-traded Treasury Bonds (eTBs) issued by the federal government are listed on the Australian Securities Exchange (ASX). Interest is paid every six months, and some pay a coupon rate as high as 5.75%. But if you'd prefer to diversify across a variety of bonds, one of the easiest options is a managed fund.
A variety of bond funds (often marketed as "fixed income" funds) is available both as unlisted funds and exchange traded funds (more on this later).
As bonds are generally regarded as lower risk (especially if they are backed by a state or federal government) the returns can be low.
ASX/Russell Investments report that Australian bonds averaged 6.2% in gross returns per annum over the 10 years to December 2017. Without the benefit of any tax breaks, the after-tax return drops to 3.3% for high income earners.
That's where Australian shares can provide an edge. The right shares can generate healthy dividends with the advantage of tax-friendly franking credits, plus long term capital growth.
Some of the sharemarket dividend heavyweights include retailer JB HiFi (dividend yield of 5.96%) and Wesfarmers (former owner of Coles supermarkets and current owner of Bunnings Warehouse, Officeworks, Kmart, and Target) with a yield of 6.72%.
Along with the big banks, which have a track record of strong dividend yields, other big yielders are Transurban (4.69%), AGL Energy (5.4%) and Telstra (4.67%).
There is a downside to focusing on high yielding shares.
"A company or portfolio of companies that pay high distributions are generally mature businesses. The capital value of these companies may continue to grow, though the rate of growth is generally lower than a low dividend paying, growth company, which may be investing more of their profits back into the business to achieve growth," Dunbar explains.
The other catch is that as a direct investor it can be hard to achieve a diverse portfolio. Anything that affects a company's profits will filter through to the dividends it pays. It makes spreading your money across a generous basket of shares a must-do to create a stable, sustainable income stream.
That's where managed share funds can again provide an affordable solution. Unlisted managed share funds are available through financial institutions such as Colonial First State, BT and Westpac.
The downside can be high fees. Canstar found the annual management fee (MER) on unlisted Australian share funds can average between 1.09% and 1.32% though some also charge additional performance fees. On top of this, the minimum opening investment can be $5000 although some funds have lower minimums.
ETFs work quite differently. They typically aim to replicate a particular stock market index, so they encompass a broad range of underlying shares. And, as they're listed on the ASX, ETFs are easy to trade, you'll only need $500 to get started, and investors have the benefit of trading tools such as stop orders and limit orders.
The real clincher of ETFs is that they charge low fees. As a guide four ETFs shared the Best Australian Share ETF award in Money's 2019 Best of the Best awards and their fees ranged from 0.14%-0.35%. Returns have also been strong.
For example one of the joint winners was the SPDR S&P/ASX 200 Fund (ASX: STW), which has a low 0.19% fee, It has clocked up average annual returns of 9.85% and 6.83% over three and five years to January 31, 2019 respectively. The dividend yield is 4.39% so investors have pocketed both capital gains plus decent dividend income.
Another joint winner - the Vanguard Australian Shares ETF (VAS) - charges 0.14% and returned 9.90%pa and 6.92%pa over three and five years to January 31, 2019 with a dividend yield of 4.38%.
The other two ETFs that shared the top spot were the iShares Core S&P/ASX 200 ETF (IOZ) and VanEck Vectors Australian Equal Weight ETF (MVW) with fees of 0.15% and 0.35% respectively.
The iShares Core S&P/ASX 200 ETF had an average annual return of 9.91% and 6.86% over three and five years to January 31, 2019 and a distribution yield of 4.40%. The VanEck Vectors Australian Equal Weight ETF returned 12.92%pa over the three years to January 31, 2019 and a dividend yield of 4.17%.
ETFs that focus on particular segments of the ASX rather than the top 200 companies, can also be a source of regular income.
The SPDR S&P/ASX 200 Listed Property Fund (SLF), which took out Money's 2019 Best Specialty ETF category has achieved returns of 8.57%pa and 13.16%pa over the three and five years to January 31, 2019, with a dividend yield of 4.78%. The fee is 0.40%.
Meaghan Victor, head of SPDR ETFs - Australia at State Street Global Advisors says: "High yielding ETFs can be an effective way to create a sustainable and diversified income stream through a single investment, while also benefiting from diversification."
Victor notes that SPDR's high yielding ETFs include a screen or bias towards higher quality companies with a history of providing stable dividends.
Nonetheless she cautions it is "important to look under the hood of the ETF, and do your due diligence before investing. Some important questions to ask include - What is the investment strategy? What does the fund invest in?"
This matters because you need to be sure dividend income is sustainable over the long term, and not just a flash in the pan.
"Companies that have consistently maintained dividends for many years, tend to have strong businesses. Conversely, companies with higher debt and lower earnings growth may be more likely to cut their dividends. Other companies that have enticed investors with headline dividend payouts early on may later disappoint by cutting or even failing to pay dividends in the next dividend cycle," Victor explains.
On the plus side, ETFs can be as tax-friendly as directly held shares. Dunbar says franking credits are fully passed through from an ETF to the investor.
Details of how often distributions are made can be found on an ETF provider's website. Most pay semi-annually or quarterly.
"Investors should review and compare the distribution history of different ETF providers to confirm that distributions are paid regularly and to determine if distribution amounts are stable," Dunbar adds.