Income Siren Song And ETFs

The hunt for income remains as fierce as ever after years of rock-bottom interest rates.

Investors in developed markets are being forced to consider riskier assets instead of traditional, steady income-generators that now offer paltry yields, such as UK government bonds.

With returns being squeezed, low-cost exchange traded funds potentially serve as an efficient way to gain access to income-paying assets, from global equities to master limited partnerships (MLPs).

"Over the last few years, more income-focused ETFs have been launched," said Adam Laird, passive investment manager at discount broker Hargreaves Lansdown. "To get extra income in this low interest rate environment means taking extra risk."

Avoiding ETFs?

Many investors still shy away from ETFs targeting an income. A poll at ETF.com's annual Inside ETFs Europe conference in June revealed 67% of the audience do not use ETFs for income focused areas of the market, opting instead for actively managed funds.

Tom Becket, chief investment officer at Psigma, believes passive investments are not the most efficient vehicle for seeking income in the current environment.

"Our view is that ETFs are not the best way to try and generate income in global asset markets, not least as the significant rise in asset prices and distortion of global bond yields has reduced the income available from many indices," he said. The income shortage is particularly acute in global sovereign bond and investment grade credit markets, he notes.

Indeed, a number of investors are concerned about the prospects for parts of the bond market, as interest rates are poised to rise in the coming year in parts of the developed world, while liquidity is drying up.

Shaun Port, chief investment officer at wealth manager Nutmeg, says he would not recommend buying into high yield bonds or longer term corporate debt as a result. He notes that the 'most value' can be found in products tracking highly diversified, short term bonds.

However, one issue particular to bond ETFs is the construction of the indices, which often results in high weightings in the most indebted companies.

For some investors, taking on such additional risk does not justify the return. Another poll at ETF.com's conference showed 100% of the voting audience were concerned about the amount of risk being taken in attempts to gain income.

Taking More Risk

Even conservative investors are being pushed into riskier equities and relatively illiquid asset classes to gain an income, such as emerging market debt.

"Some strategies invest in exotic areas and might be less liquid—you may struggle to get your money back if markets crash," Laird said. "In particular, it's important to scrutinise newer products—some of these strategies are untested in all market conditions."

One new strategy in the UK that has already taken hold in the US is ETFs that track MLPs. These products invest in infrastructure assets, typically linked to energy, which must distribute most of their revenue to investors. ETF Securities, for example, has launched the US Energy Infrastructure MLP GO UCITS ETF (ticker: MLPX) product, as a way to access the so-called US energy revolution.

However, Laird points out that there are two significant risks: "Many MLPs dropped suddenly when the oil price fell in late November 2014," he warned.

"Secondly, [watch out for their] US dollar exposure—if the pound continues to strengthen it could impact UK investors' returns."

Be Diversified And Go For Dividends

Lower risk, more traditional strategies can be created with a diversified portfolio involving a degree of exposure to products aimed at enhancing income.

Peter Sleep, senior portfolio manager at Seven Investment Management, said, "It is of course possible to build up a globally diversified, low cost portfolio of trackers and ETFs. But the income on these portfolios tends to be quite low, say 2 to 3%, reflecting the low yield in many core markets like gilts or the US and Japanese equity markets.

"Investors can boost their income somewhat by focusing on income tracker funds or ETFs which invest in higher yielding stocks," he added.

Such dividend boosters include so-called Dividend Aristocrat or Dividend Select ETFs, some of which hold equities that have consistently increased dividends over a number of years.

In Europe, the SPDR S&P Euro Dividend Aristocrats ETF (ticker: EUDV), for example, tracks an index which incorporates the longer term sustainability of a company's dividend into its methodology—it selects the highest yielding companies that have increased or maintained stable dividends for at least 10 consecutive years.

"These funds are fine, and picking stocks on the basis of their dividends is a probably a winning strategy over time, but they can underperform for periods," said Sleep.

Beware The Pitfalls Of Income Boosters

The buoyant US stock market has been led this year by the low dividend paying technology sector. By comparison, the iShares Dow Jones Dividend Select UCITS ETF (ticker: EXX5) has underperformed the S&P 500 by nearly 8% over the same period because it focuses on the 100 leading stocks by dividend yield from the Dow Jones US Index.

Nutmeg's Port also pointed out some other risks worth considering in relation to ETFs that select high-yielding stocks.

"Whilst this strategy may look most attractive at the time of investment given the high current income, it can quickly become expensive as investors crowd into it, reducing the dividend yield as prices rise," he said.

"This is especially true in the current low yield environment, where traditional 'bond proxy' stocks have seen large volumes and rising correlation with the bond market," added Port.

Dividend yields may also seem attractive because there has been a sharp fall in the stock's price, potentially reflecting underlying weakness in the company. Another risk is that companies must be able to sustainably grow dividends so the yield is not eroded by inflation over time.

Choosing The Right ETF

While there are risks involved with investing in a number of asset classes, careful ETF selection can provide a low cost way to generate income.

Psigma's Becket said Vanguard's FTSE All-World High Dividend UCITS ETF (ticker: VHYL) is an efficient way to exploit global dividends in equity markets. The fund excludes all stocks that are not forecast to pay a dividend and currently pays an attractive income of 3.6%, while charging only 0.29% per year, he noted.

For investors insistent upon income, Becket suggests the iShares £ Corporate Bond Interest Rate Hedged UCITS ETF (ticker: SLXH), which allows investors to benefit from the higher yields of corporate bonds without the fear of rising interest rates, and an attractive yield of 3.6%, he said.

Ultimately, the range of income focused ETFs continues to expand, and careful selection is key to achieve attractive returns while safeguarding capital.