With interest rates at all-time lows, many people with money parked in cash accounts and term deposits are looking elsewhere for income. Investing into a diversified portfolio of low-cost exchange-traded funds (ETFs) which include high dividend stocks can help you reach your dividend income objectives, but comes with a different set of risks. If these risks are properly managed you can strike the right balance between income and risk to achieve your goals.
Investing for income
There are different ways to invest for dividend income via the share market – you can invest in shares with high dividend yields like banks, Listed Investment Companies (LICs), REITs or ETFs. Each comes with its own set of benefits and risks. The Stockspot Portfolios invest into low cost ETFs across a range of asset classes. While we don’t specifically invest for dividends, our portfolios have generated an average annual income return of 1.8% to 4.3% (including franking credits) per financial year since 2014.
What you can see from the trend below is that income has been falling steadily over the last few years. This has been in line with the Reserve Bank of Australia (RBA) official cash interest rate, which has also been falling. Income from assets like property, shares and government bonds tends to have a strong link with official RBA interest rates. When the RBA cuts interest rates, assets that generate income often rise because investors are attracted to their relatively higher yield. If the price of an asset rises but the income it pays remains the same, then the dividend (or income) yield falls. This is exactly what’s happened over recent years.
During the 2021 financial year, the Stockspot Portfolios returned income between 1.8% and 2.4% p.a. (including franking credits).
Franking credits add income
Franking credits are a tax rebate that Australian resident shareholders receive when companies pay dividends from their Australian after-tax profit. If you own an ETF, you are entitled to the franking credits passed on by all of the companies within the ETF. The Stockspot Portfolios have been able to generate an extra 0.2% to 0.4% in FY21 from the underlying ETFs passing through franking. Our recommended Australian shares ETF offers a relatively high level of franking credits.
How to increase the income yield of your portfolio
Generally speaking, assets with high dividends come with higher risk on the capital side of the equation. An ETF paying a high distribution income of say 4% may only generate a capital return of 2% giving you a total return of 6%. On the other hand, the broad Australian market ETF may pay an income of 2% but deliver a capital return of 6% giving you a total return of 8%. This is why we prefer to focus on total returns.
For clients who have over $50,000 we do offer Stockspot Themes to customise your portfolio. Stockspot offers many themes which have historically paid higher than average income (see table below). However, if you’re considering adding more income-generating investments, be aware that this often comes at the expense of capital returns.
|Theme||Distribution Yield (income)||Franking Level %||Distribution frequency|
|Australian dividend shares||4.2%||86%||Quarterly|
|Australian large companies||3.7%||41%||Quarterly|
|Australian socially responsible shares||3.4%||50%||Semi-annual|
|Australian Corporate Bonds||3.0%||0%||Quarterly|
A total return approach to investing
A total return approach to investing combines both the capital return (the price of the investment rising over time) and income returns. We prefer this approach compared to only focusing on income because it allows you to maximise your overall return potential while controlling for risk. This video explains more on why this is our preferred income investing strategy.
Investing with total returns in mind gives you the flexibility to draw down from both the income and capital part of your portfolio if needed. It’s also a lower risk strategy compared to only investing in high-income assets which are prone to capital losses and poor diversification. Over the last 5 years to the end of June 2021, our total return approach has achieved returns of 7.6% to 12.0% per year after fees.
The next time you see an investment advertised with a high income return, ask yourself “what risk am I taking on my capital to achieve this high income?”. There’s no free ride with income investing, the catch with any investment with high dividend is that your capital is always at risk.
By taking a total return approach, the Stockspot portfolios have been able to perform more consistently in up and down years. Even in 2020 when most fund managers and super funds posted negative returns, all of the Stockspot portfolios had positive performance.