When people think of ETFs, broad-based equities are often what comes to mind first.
But for income seeking investors, ETFs offer a wide range of options.
Many of these now offer significantly higher yields than a just a couple of years ago, while others may offer franking credits to boost after-tax income.
Read to the end to learn about a popular way to build a portfolio for income. But first, here are four types of assets investors can use to generate income from ETFs.
Equity income
Australians have long been attracted to equities for their dividend yields and franking credits, but there’s more to equity income than just buying blue chip stocks for their dividends.
Some strategies involve selling options to boost income and potentially lower volatility. Others aim to ‘harvest’ dividends and franking credits by regularly rebalancing into companies that are expected to pay a dividend in the months ahead.
Why equity income?
- Equity income can provide an attractive income stream from a portfolio of equities, often with distributions paid monthly or quarterly.
- Some strategies may offer tax advantages, such as franking credits, helping investors maximise their after-tax returns.
- Investors may benefit from potential appreciation in the value of the underlying stocks.
Hybrids
Hybrids have elements of both bonds and shares, and sit somewhere in between the two for levels of risk and return.
They’re typically issued by corporations, and in Australia, banks are by far the most common issuer.
Individual hybrids can be complex. For this reason, a professional investment manager can be helpful in navigating this asset class.
Why hybrids?
- Hybrids generally offer a higher level of income than shares or fixed income, with a greater level of capital stability than shares.
- They can offer franking credits, improving after-tax returns.
- Betashares’ hybrid funds pay distributions monthly.
Fixed income
Fixed income plays a key role in investors’ portfolios, providing income and defensive attributes. It also offers diversification benefits for investors with equities in their portfolio.
Investing in fixed income is essentially buying debt, which the borrower needs to pay back, with interest. Depending on the credit worthiness of the borrower, and the length of time until the money is paid back, the yield may be higher or lower.
Why fixed income?
- Fixed income typically offers a higher level of capital stability than equities.
- Some types of fixed income, particularly long-term government bonds, may offer a negative correlation to equities. This means that the value of the bonds increases as share prices fall, helping to smooth out volatility.
- It offers a consistent, and more predictable income compared to share dividends, with distributions paid monthly or quarterly.
Cash
For investors relying on their investment portfolio for income, cash is king. It offers flexibility, liquidity, and certainty.
“If cash is so great, why don’t I just put everything in cash?”, I hear you ask. Well, cash has historically produced lower returns than other asset classes over the long term. But cash is still a reliable option for managing short-term needs.
The good news for investors is that cash is currently offering the best rates in more than a decade.
Why cash?
- Regular income with high levels of capital stability
- Low risk
Note: An investment in AAA is not the same as a deposit with a bank. An investment in AAA does not receive the benefit of any government guarantee.
Investing with buckets
Investing for income requires a different mindset an approach to accumulating your nest egg.
For example, during the accumulation phase, volatility can be beneficial for long-term returns, allowing investors to purchase assets at a lower price. But once you’re drawing down on investments, volatility – particularly during the early phases – can have a serious impact on how long your money lasts. This is known as ‘sequencing risk’.
One popular strategy that aims to manage the risks investors face during drawdown is called a ‘bucket strategy’. This strategy involves splitting your funds into three ‘buckets’:
- Cash. This typically contains a year or more living expenses, and possibly an ‘emergency fund’ for unexpected expenses.
- Fixed income. As the cash bucket depletes, attention shifts to fixed income, this bucket aims for stability, but is less conservative than the cash bucket. It’s generally anchored with high quality government and corporate bonds, but may include a modest allocation to hybrids or lower grade bonds.
- Growth. Investment doesn’t end at retirement. For people aged 60 today, life expectancy is 24 years for males and 27 years for females1, allowing more than two decades for investment. As such, growth investments may still form an important part of a retirement investment strategy. Growth investments typically include shares, and may include property or other growth assets.
The goal is to fund living expenses from the cash bucket, along with any distributions or dividends from the other buckets.
If the cash bucket gets low, it can be topped up by selling down assets in either the second or third bucket, depending which has performed best recently.
This acts as a form of rebalancing, allowing investors to get back to their target allocations.
Keep it simple
Retirement is a time of great change, but it doesn’t need to be overly complex. Four types of ETFs and three buckets are a good starting point. Though a qualified financial adviser can be an invaluable resource, helping to guide your way.