Two things are needed to be a successful income investor. You must have the patience to stay the course with existing positions so income compounds over time. You must also continually focus on the best place to invest your next dollar for future income growth.
This dichotomy can be difficult to navigate. Long-standing positions with significant unrealized capital gains may still be delivering for your portfolio while not being the ‘best’ place to invest the next dollar.
The Australian market has delivered for income investors in the previous decades – but what if that golden age of dividends is coming to an end?
This is not a call to overhaul your portfolio. However, it is worth considering other options for investing your next dollar if you are an income investor. Here are four choices for investors who share a concern about the companies and sectors that dominate the local market.
Alternate options for income investors
The goals of income investors are not uniform. Some income investors are concerned with the highest possible current yield and some are more focused on income growth.
Where you fall on this spectrum will dictate the relative attractiveness of each of these options.
Broad exposure to the Australian market in a non-market capitalisation weighted ETF
For investors with specific goals – like generating income – a broad-based index may not deliver the desired outcome. This is the case for most global investors. But Australia is different and historically a passive approach to the Australian market worked out for income investors.
The outcomes for market capitalisation weighted indexes are heavily reliant on the largest companies. If you are worried about the largest companies, you can buy ETFs that either reduce their exposure or avoid it altogether. Two examples are the BetaShares Australian Ex-20 Portfolio Diversifier ETF (ASX: EX20) and VanEck Australian Equal Weight ETF (ASX: MVW).
As the name implies, the EX20 ETF avoids the twenty largest companies in the ASX 200 and applies individual holding and sector caps to limit concentration. The VanEck ETF has an equal allocation to the top 74 companies in the ASX 200, although the number of holdings may change based on liquidity criteria.
However, both MVW and EX20 experienced the same challenges with the June distribution with each falling 40% from the previous year.
One data point isn’t a trend and I still believe reducing exposure to the largest companies is the right move for long-term income investors. But it is important to acknowledge the same challenges faced by the big miners and banks also impact smaller miners and banks. In most cases the challenge is greater given their lack of scale.
It is hard to avoid sector concentration in any diversified Australian share ETF. But given the top-heavy nature of our local market the return and income profile of MVW and EX20 will be different from the ASX 200.
There are downsides to investing in both ETFs. An investor will likely face a higher capital gains component of the distribution – especially for MVW – and a higher fee than the broad-based index. Whether that is worth it is based on your goals, your view of the Australian market and the other holdings in your portfolio.
Listed Investment Companies (LICs)
There are several structural advantages and disadvantages of including LICs as part of an income portfolio.
The company structure allows the retention of profits and provides the LIC manager with the discretion to distribute income and franking credits at a time of their choosing. This can smooth out any income cyclicality in the underlying holdings and provide a stable stream of income and franking credits to investors.
A steady stream of income is valuable to investors living off dividends – especially in challenging times. For example, during the pandemic many LICs were able to maintain a degree of dividend stability even as many companies were suspending or cutting dividends.
The following chart shows the percent change in distributions / dividends for three major LICs compared to the Vanguard Australian Shares ETF.
Another advantage is LICs can provide franking credits from a variety of assets and not just Australian shares. A LIC that invests in global shares can still have franking credits because the LIC is an Australian company which makes profits and pays taxes in Australia.
The closed end structure of a LIC has advantages and disadvantages. The LIC share price is set by supply and demand from investors and can deviate meaningfully from the value of the underlying assets. There is no mechanism to keep the net tangible assets (“NTA”) in line with the LIC price like an ETF or a fund.
This adds another element to the total return for a LIC investor. Not only does the skill of the manager matter in the capital growth of the LIC but also the behaviour of other LIC investors. Many LICs trade at a discount to the NTA but they could just as easily trade at a premium if investor demand for LICs increased.
The closed structure does provide freedom for the manager, which is one reason I would consider a LIC while avoiding other active strategies. The capital raised from investors is ring fenced and isn’t impacted by investors moving into and out of the fund. This is something a manager of an open-ended managed fund must deal with which can restrict their freedom of action and lead to short-term behaviour.
The challenge for LIC investors is evaluating the skills of the LIC manager. This matters because a skilled manager can avoid companies with poor dividend prospects. But it can be difficult for an individual investor to assess the skills of a manager as the only tools available are the historical track record and marketing material.
Individual shares
Part of the reason I became an income investor is because it is more straightforward. Achieving financial freedom by hitting some arbitrary level of wealth was abstract. Generating enough passive income to pay for my life was clear.
In my opinion, picking individual shares for income is more straightforward than finding shares with a total return objective. That doesn’t make it easy – but I think it is easier. You still need to evaluate a business because without earnings there are no dividends. But you don’t have to try and figure out how investors will react to different scenarios.
There is no need to worry about catalysts, sector rotations, sentiment or expectations. You just look for companies that will likely make more money in the future and have a track record of returning it to shareholders. There are fewer variables that impact success when you narrow your focus to income.
There are other advantages to investing in individual shares with an income focus.
Behavioural risk is lower if you focus on dividends and place less emphasis on price movements.
Companies that pay dividends are generally more mature, stable and financially healthy, which makes it less likely they will go out of business. This limits downside risk.
Many dividend paying companies are boring which means you don’t have to evaluate cutting edge technology and the shifting competitive environments of new industries. You still need to understand the dynamics of the industry for a dividend paying share…but some industries are more complex to evaluate than others.
When you hold individual shares you can pick the timing of capital gains. You have more transparency into why income levels are changing. You don’t have to pay any fees. You get complete control over your positions which means you can avoid sectors and companies that don’t have attractive prospects for dividends.
There is one big disadvantage. Picking individual shares is more challenging than buying a diversified ETF. Managing a portfolio of individual shares takes more time and effort.
Picking individual shares isn’t about having a high IQ or special talent. It just involves some effort to gain knowledge and evaluate companies. Some people prefer to focus on other aspects of their lives – financial and otherwise. I personally gravitate towards individual shares but you can still be successful avoiding them and for many people that is a sensible choice.
Covered calls
The ‘best place’ to invest the next dollar is dependent on what you are trying to accomplish. For some income investors ‘best’ may be the highest yielding investment. For others it is all about income growth.
I’m in the income growth camp, and I wouldn’t consider a covered call strategy at this point in my life. But I do see why it is attractive to some investors and could see myself potentially using it in a limited way in a few decades.
A covered call strategy is a technique used to generate additional income from a portfolio of shares. The effectiveness in generating additional income is offset by limits on capital gains.
If you are considering investing in a covered call ETF I would encourage a detailed review of how they work – I wrote one here. But the summary is the ETF holds a group of shares and sells call options.
In exchange for the cash, the ETF gives the buyer of the call the right, but not the obligation, to buy the shares at a price above the current price of the shares.
If the shares rise in value the upside is capped because they are purchased by the holder of the call option. If the shares fall in value the ETF goes down in price. The trade-off is income consisting of the dividends from the shares and the cash from the call options.
There are also tax considerations as this strategy has the potential to generate significant capital gains.
The performance of a popular ETF
I will use the BetaShares Australian Top 20 Equities Yield Maximiser Complex ETF (ASX: YMAX) as an example.
Investing $10,000 on 1 August 2021 at the open price of $8.35 would result in 1197.50 units. Slightly less than five years later the units closed at $7.46 on 22 July 2026. The $10,000 investment would now be worth $8,933.35. But the income generated over that period is an impressive $3,704.82.
The total annual return over the past five years is 6.49%. That compares to a 7.91% annual return for BetaShare’s Australia 200 ETF (ASX: A200). But those annual returns assume distributions are reinvested.
If you are not reinvesting the distributions – and I assume many people in this product aren’t – things don’t look quite so good.
Each investor will have to decide if this trade-off is worth it. When you invest in the share market you benefit from the asymmetric nature of returns – a share can only go down 100% but has an unlimited upside. A covered call ETF is different as higher levels of income are exchanged for capped upside and the same downside of the overall market.
Final thoughts
Yesterday I got $536 closer to going to Africa. Last week I got $140 closer to financial independence. This is life as an income investor.
In an account I use to fund travel the most recent dividend from Cisco will help pay for a trip next year. In another account I bought an ETF which should pay $140 in distributions next year – and hopefully will pay a growing stream of income for the rest of my life.
Income investing isn’t a get rich quick scheme and it isn’t about investing in the companies on the front page of the paper – hence my call for patience and a non-consensus approach.
There are many tools that income investors can use and each has a unique set of advantages and disadvantages. The job you are trying to do will dictate which combination of tools works best.
To be a successful income investor requires the same framework as any other investment strategy.
Start with clearly defining what you are trying to accomplish – is income growth or high current levels of income the best way to support your life?
Establish criteria for making the inevitable trade-offs involved in investing and select the right investments for you based on your goals, your temperament and your knowledge and skills.
Once the framework is in place, focus on consistently applying your strategy over the long-term.
Mark LaMonica, CFA, is Director of Personal Finance at Morningstar Australia.