Income investing with ETFs

Exchange traded funds that pay a good dividend yield can be ideal for income seekers. Here's what you need to know.

Income investing with ETFs While commentators frequently discuss the gyrations of share prices and the highs and lows of the stock market, we seldom hear so much about income.
Yet reinvesting the income paid by shares, bonds, and other investments can make all the difference to growing your wealth. Investors also often look to their portfolios to provide the income they need to live on.
And from April, new pension freedoms – which give pensioners more flexibility in deploying their savings – seem likely to make income investing even more popular.
In the past, annuities, bonds, and cash featured prominently in most income-focussed portfolios. But years of near-zero interest rates have crushed the income you can achieve from these traditional sources.
Instead, investors increasingly look to dividends from shares to address their income needs.
Exchange Traded Funds (ETFs) offer a flexible and economical way to do this.

Income also-rans

Some private investors buy individual company's shares for income. They may believe they can cherry pick the best prospects. However studies have shown most will fail to beat their benchmark.
Buying a portfolio of blue chip stocks can be costly due to multiple trading fees and stamp duty. And even a relatively large portfolio of 30-40 stocks is not as diversified as an index tracker, and hence riskier.
Another option is an actively managed income fund or investment trust. These address the diversification issue, and a handful of managers can also point to a record of outperformance.
However most funds will not beat the market. Yet regardless of whether yours does, you will still pay steep annual management fees, as well as hidden costs such as high transaction costs if your manager trades a lot.
Income investment trusts have been popular with UK investors for many years, pre-dating ETFs. However as well as high charges they introduce another complication, which is that unlike ETFs, investment trusts often trade at a premium or a discount to the value of their holdings.
This means you might pay over the odds to buy into a trust, or that you may have to sell it for less than it's worth. Most investors can do without such hassles.

ETFs: The superior way to income

We believe a portfolio of well-chosen ETFs offers the best all-round income solution.
You can select ETFs that invest in different categories of income paying shares (or even other assets, like government bonds) to suit your needs. And an ETF's assets are spread across many shares, just like other funds.
So with just a handful of ETFs, you can build an income portfolio far more cheaply than buying several dozen individual shares, and it'll be less risky, too. Yet because ETF fees are much lower than those of an actively managed fund, you'll also save money on annual costs.
This means more income for you to reinvest or to spend.

Understand your ETF

Once you've decided to use ETFs, the deep research begins.
Many ETFs pay a dividend income – including many ETFs not specifically aimed at income seekers. Even a FTSE 100 or MSCI World ETF might be considered for an income portfolio.
The income an ETF pays out depends on what it is holding, and whether the ETF has been set up to pay out the income it receives from those holdings, or to reinvest the proceeds within the ETF for future capital gains. Thus, in particular distributing ETFs qualify as a passive source of income.
Even among ETFs specifically targeted at income seekers, there are choices. These indices select high dividend yielding stocks of a country or region according to specific criteria. As the approaches differ sometimes significantly, it is recommended to look deeper into their methodology before investing.
Our introduction to global and European dividend ETFs will help get you started.

Dividend yield explained

Dividend yield is another critical factor in determining an ETF's potential for income.
The dividend yield relates the income paid out by an ETF to its share price:
Dividend yield = Annual dividends per share / cost per share
If an ETF pays 75p as a dividend and it costs 1800p to buy, the yield is:
75p / 1800p = 4.17%
When we speak of dividend yields, we might refer to the historic yield, which is based on the past 12 months of dividends, or the current yield, which is based on the next 12 month's forecast dividends. A good estimate for future distributions is the dividend of the past 12 months. As prices fluctuate, the absolute annual distribution provides information about the consistency of the dividend.
If you are investing for future income, the current/forecast yield is key. Just remember that for equities this is a 'best guess', not a guarantee – a crucial distinction when compared to the more certain return from bonds or a fixed-rate cash savings account.
A high dividend yield is not always the best investment, even for income seekers, if the security of the income is uncertain, or if it's too volatile. Remember too that income is only one component in the potential gains from shares.
A lower yielding ETF might hold companies that attract investors for reasons other than income, and so could outperform in total return terms.
Nevertheless, the current dividend yield is a good starting point for finding interesting ETFs for an income portfolio. Our top 50 lists of ETFs with the highest dividend yields will give you an initial overview.


Hunting high and low

You can also research ETFs for income using the justETF screener. We publish both the historic and the current yield of distributing ETFs as well as the annual distribution amounts.
Happy hunting!