Much ado about income

Ultimately people invest expecting to generate a positive financial return over time. These expected returns are generally correlated to risks; the lower the risk, typically the lower expected returns, while higher returns are usually accompanied by higher risk. Risk, we think for many investors, is the risk, or likelihood, of losing the money invested.

Returns from every investment will come from two sources, growth and income. Growth is the growth of the principal investment. Say, for example, you bought a share in a company for $100 and a year later it was worth $110. Your investment has experienced 10% growth.

If at the end of the year, the company also paid a dividend of $5 per share, your investment experienced a 5% income return.

The total return, growth and income combined, was 15%.

Depending on your investment objective, you may be interested in growth, or you may be interested in income. Income can be spent by the investor as soon as they receive it, growth, on the other hand, may not be realised until the investment is sold.

In the simple example above, the investor received $5 cash from the dividend income. However, they did not physically receive the $10 cash from the share price growth. They would only ‘receive’ that gain if they sold the share.

One of the features of our superannuation system is that as more and more Australians retire, it is likely they will become more and more reliant on their investments to provide income. Therefore, income investing is something every Australian worker will need to consider, including Millennials, Gen Z-ers and the generations that follow. This is because it is likely the government-subsidised pension system will be different to what past generations experienced. By the time younger generations hit retirement, and investments in and outside of super will become paramount for income.

It is therefore paramount all Australians understand the income options available to them.

Income investing involves structuring your investment portfolio to focus on generating regular, consistent income. Many different types of investments can deliver regular income. These include term deposits, investment property, certain shares and bonds.

All of these ‘income’ investments involve varying degrees of risks and as a result, the income expected from each of these is different. An investor, for example, would expect to receive a lower rate of income from an Australian government bond, than they would expect to receive from an Australian corporate bond. This is because the Australian government is less likely to default on its loan than an Australian company issuing a bond.

Because of the complexities of managing portfolios for income, many investors use income-focused funds like ETFs (Exchange Traded Funds) to meet their investment goals. These can include ETFs that invest in bonds, listed property, listed infrastructure, equities or listed private credit. Each asset class is different, so let’s look at these to help understand what to look for, and how to potentially use them in a portfolio.

Banks (and equity ETFs)

Many income seeking investors are likely to be attracted to equity-income generating assets such as banks, which pay franked dividends. Investing in equity markets can be more volatile but can often yield bigger rewards for the increased risk.

Companies such as banks appeal to investors because they may deliver two potential sources of return: income from the dividends as well as the capital appreciation of the stock price. Other sectors historically associated with dividends are utilities and telecommunications.

Some ETFs focus specifically on ASX-listed companies that pay dividends, while others focus on sectors known for their income, like banks.

Bond ETFs

Bonds are a type of loan set over a fixed period. Investors lend money to a bond issuer and in return, they will receive regular interest payments until the bond matures, when they will receive full repayment of their capital.

We have written about bonds here - Bond basics and the most important factor affecting bond prices

And you can learn about learn more about bonds, the risks and the opportunities in this brochure.

ETFs have made it much easier to access bonds from across the globe.

Not all bond ETFs will pay the same level of income, because each has different underlying holdings, so will have differing risks. It is worthwhile to understand some different types of bond ETFs. Details of the different types of income ETFs are summarised here at our income investing microsite.

Listed private credit ETFs

Private credit companies generate income by lending to and investing in non-public businesses using a variety of sources, such as debt and hybrid financial instruments. In short, they provide capital to small and medium-sized private businesses, and in turn, give investors access to the growth and income potential of private credit that are generally exclusive to large institutions and difficult to access.

Investors are using global listed private credit securities to enhance the yield of an income portfolio to the degree that matches their risk tolerance. Because the companies using the loans are typically smaller, middle-sized companies and the loans issued can be riskier, the interest rates associated with private credit tend to be attractive relative to more traditional income-generating asset classes.

A listed private credit ETF allows investors to access this asset class.

Property and roads (listed property and infrastructure ETFs)

Listed real estate investment trusts (REITs) are listed securities that own, operate or finance income-producing real estate. This can include office towers, hotels, shopping centres and warehouses. REITs provide an investment opportunity that makes it possible everyday investors to benefit from valuable real estate¹. Examples of REITs include property developer Scentre Group, locally which manages over 40 Westfield shopping centres and Public Storage, in the US which manages thousands of self-storage services.

Infrastructure companies play a vital role in building and operating structures and facilities necessary for a functioning society and productive economy. Examples include utilities, energy and transportation. Infrastructure investing involves owning a part of these essential assets, holding the rights to their use and benefiting from the income generated as society pays to use those resources². These income-producing assets are built for long-term use, requiring large capital spending initially and smaller ongoing costs to sustain their operations.

The problem for most income-seeking investors is that they do not have enough money to buy a shopping centre, an office block, and airport or a road.

Listed property and infrastructure vehicles emerged as a solution accessible to all investors, overcoming the drawbacks associated with investing directly in property and infrastructure. These are highly liquid, like investing in any other equities and have no minimum investments, daily pricing and high levels of liquidity and disclosures.

But as with all other asset classes, it’s important to diversify within the asset class by investing in a basket of REITs or a basket of listed infrastructure securities, rather than one. This is what global listed infrastructure ETFs and listed Australian and international property ETFs offer, with the additional benefits of ETFs: transparency, liquidity, and cost-effectiveness.

Why a smooth income experience matters

Income-focused investors prefer their portfolio to deliver a smooth series of payments into their bank account, rather than lumpy, unpredictable amounts. Smooth income is easy to do if you settle for low-paying bank accounts, but it gets much harder when you need higher returns, so invest in more risky asset classes like global property, global listed infrastructure and listed private credit.

Investing in overseas markets and hedging returns back to Australian dollars can be difficult, a thorough understanding of the capital markets and tax rules means that the wrong choice of asset manager could have a negative impact, especially if you seek an income-oriented investment outcome.

Properly consider the asset manager and their history of paying smooth reliable income. As they are transparent all ETF issuers make their distribution history available on their website. This allows for comparison.

Make sure the composition of the returns reflects your expectations. Income payments for income-seeking assets should be smooth, not crunchy.

There are a range of income opportunities

With so many income opportunities available to investors, it is important to understand all options available and their risks and benefits. This is where professional advice can help.

We think, over time as Australia’s superannuation and retirement system matures it will lead to superior long-term decision-making and active participation in markets. It will also continue to lead to innovation, especially in terms of income-focused products. ETFs are at the forefront of this innovation, helping investors access income opportunities.

Key risks

An investment in the funds carries risks associated with: financial markets generally, individual company management, industry sectors, ASX trading time differences, foreign currency, currency hedging, sector concentration, political, regulatory and tax risks, fund operations, liquidity and tracking an index. See the PDS for details.

Sources

¹Nareit, ²Investing in global infrastructure, VanEck