High-yield products with reduced risk

The search for equity income is ideally suited to delivery via index products.

Summary: Index productions, often issued via exchange-traded funds, provide a low cost and tax efficient way of delivering equity income.
Key take-out: High yields associated with low share prices may reflect fundamental problems within a company. Many ETFs have inbuilt mechanisms designed to insulate the products from falling capital value and to embed opportunities for future capital growth.
Key beneficiaries: General investors. Category: Investment portfolio construction.

In the current world of low interest rates, investors are flocking to “equity income” products as a way of generating cash flow for retirement.

Defensive stocks like Telstra and the Aussie banks provide income with relative capital stability, but are accompanied by “concentration” risk. Over the last few years investment providers have created a range of diversified equity income products that aim to emulate or better the returns from single defensive stocks. These include a variety of mechanisms designed to spread the risk of capital loss or diversify the sources of income enhancement.

Typically these products provide access to technology that is difficult for retail investors to access directly or at a reasonable cost, and are based on innovative indices (improving transparency) and with reduced costs compared to traditional actively managed funds.

New forms of index investing

The search for equity income is ideally suited to delivery via index products – often issued via exchange-traded funds (ETFs) which track these indices. The indices are designed to screen for factors like dividend levels and growth, sectorial diversification, liquidity and capital stability (often linked in the indices to measures of value and NTA). These ETFs are issued by providers like Blackrock (I Shares), Vanguard, Russell, State Street and BetaShares (see table below).

Table 1: Listing of Income ETFs

Provider

Fees

Key Components

I Shares S&P/ASX Dividend Opportunities (ASX Code “IHD”)

0.30% pa,

53 stocks, quarterly distributions

Vanguard Australian Shares High Yield ETF (ASX Code “VHY”)

0.25% pa,

60-70 stocks, quarterly distributions

Russell Australian Shares High Dividend ETF (ASX Code “RDV”)

0.34% pa

ASX stocks, quarterly distributions

StateStreet SPDRS Australian Select High Dividend Yield Fund (ASX Code: “SYI”)

0.35% pa

ASX stocks, quarterly distributions

BetaShares S&P/ASX 20 Equity Income Maximiser (ASX Code “YMAX”)

0.59% pa

20 stocks, “covered call” option writing strategy, semiannual distributions

Risks associated with equity income investing

The main problem with buying stocks based on their current dividend yield is that high yields associated with low share prices may reflect a “dividend trap” – where the company is suffering a fundamental erosion in fortunes that is masked by a high return generated from past cash flow. Typical in the broad-based ETFs listed above are mechanisms that assess forward earnings growth (based on market forecasts) as well as using a variety of measures to assess fundamental value. These factors are designed to insulate the products from falling capital value and to embed opportunities for future capital growth. Sectorial diversification and ongoing re-balancing are also commonly used to further improve the defensive profile of the products.

These factors are based on quantitative measures, and do not include any qualitative assessment of the fortunes of the component stocks. In this way the portfolio construction can be driven by the underlying index on which the product is based. This aids the significantly lower costs for these ETFs compared to traditional actively managed funds.

These broad-based ETFs provide lower brokerage costs compared to investors compiling the underlying share portfolios themselves, especially when the overall amount invested is relatively small (noting that typical online brokerage rates include a minimum fee per stock).

Relatively low turnover and a focus on franked dividend paying stocks promote the tax efficiency of these ETFs. Specific details for each ETF are available at each issuer’s website.

Income returns from these ETFs during the calendar year 2013 are shown in table 2 below:

Covered Call Options – Income Enhancement

The BetaShares YMAX ETF includes a rules based “covered call” option writing mechanism to enhance income. This feature sells individual call options over each of the underlying shares, and the premium received is added to the dividend income on the underlying shares. The covered call mechanism is a way of “monetising” some of the future capital growth potential of the underlying shares, and is especially useful in flat or sideways trending markets. Further information regarding the performance of covered call strategies is available at the ASX website: www.asx.com.au

Conclusion

Equity income investing is a more risky way to generate cash flow for retirement living compared to cash or term deposits. However, this risk can be mitigated by selecting stocks with solid defensive characteristics, and this can aid the prospects for capital growth over time (although this capital growth will typically be muted compared to more volatile stocks).

Low fees and good tax efficiency combine with the transparency of these index-based ETFs to provide useful tools to diversify investors’ portfolios when seeking higher levels of income.


Dr Tony Rumble provides educational services to BetaShares and to ASX.