X-Plained: What is Income Investing?

Generating income is a priority for many investors. From those approaching retirement to younger investors who are looking to diversify their portfolio, income-generating assets can play a vital role in portfolio construction. Your risk profile and investment time horizon plays a significant role in determining what kind of income investments suit your needs and cash flow goals. Exchange traded funds (ETFs) offer a wide array of income solutions across asset classes and strategies.

Let’s X-Plain:

  • What is income investing and income-generating assets?
  • Why use ETFs to generate income?
  • How could income ETFs be used in a portfolio?

What is Income Investing and Income-Generating Assets?

Income investing focuses on investment strategies that prioritise earning regular cash flow. The income return from investing is also often referred to as yield – the terms can sometimes be used interchangeably.

There are a number of ways to generate income in an investment portfolio. The below are three key strategies, often used to generate income in varying market conditions and pay out income at different frequencies (either monthly, quarterly, or annually).

Fixed Income

  • Bonds are one of the most common forms of fixed income which help investors generate income and cushion portfolios when share markets fall. The US has the largest bond market in the world, which investors can access via ETFs offering exposure to government (also called Treasury), corporate and high-yield bonds.

Covered Calls

  • In short, covered call ETFs are an options-based strategy which work by holding a basket of shares and then selling an option to make a ‘call’ on what the value of those shares will be after a specified amount of time has lapsed. For providing this call, a premium is earned from the buyer, which is how income is generated.

Dividends

  • Dividends are arguably the most well-known way to generate passive income from investing – particularly in Australia given the dividend imputation system. Generally, a company will use its profits to reinvest back in the business for growth, and the remainder can be paid out as a dividend.

Read our insight article Three Ways to Enhance Portfolio Income with ETFs for more information on each strategy.

In addition to the above, investors can gain exposure to other income-producing asset classes such as cash and property.

Cash

  • Cash held with institutions such as banks can provide regular interest payments to investors. High interest bank accounts or term deposits can be attractive as a lower risk asset class, however to access the full yield potential there are often strict caveats which need to be met.

Property

  • Property covers everything from residential investment properties to commercial and industrial facilities. To buy physical property can be expensive, time consuming and comes with longer term financial commitments. Property ETFs allow investors to access this asset class in a transparent, lower cost, liquid vehicle.

Why use ETFs to Generate Income?

ETFs are an efficient, cost-effective way to access a range of asset types including those which aim to generate income. By holding a basket of securities according to specific index rules, ETFs inherently spread risk across multiple securities to provide a diversified income source. For more information, on how ETFs work, read X-Plained: What are ETFs?

For income-focused investors, ETFs are also attractive as they directly pass on generated income from the fund to unit holders, in contrast to other investment vehicles that may hold onto it. Another benefit is that ETFs are transparent, so you can see exactly what they are invested in through their underlying holdings. For instance, the Global X S&P/ASX 200 High Dividend ETF (ASX: ZYAU) lists which companies it invests in as well as their weight in the fund. The same holds true for Global X’s range of covered call and US fixed income strategies.

How Could Income ETFs be Used in a Portfolio?

Depending on your cash flow goals, timeline, and risk profile, you can position a portion or all of your investment portfolio to generate a stream of income. These factors will help determine how much of your portfolio is dedicated to income-generating assets and which kind of strategy will suit your needs. To this end, you may also consider which mix of assets will most likely deliver the desired results as a part of a well-diversified portfolio. For more information on how to tell ETFs apart, read X-Plained: How to Research ETFs.

Let’s refer to one of the most well-known portfolio allocation models – the 60/40 portfolio. This strategy is where traditionally 60% is allocated to shares and 40% to government bonds.

  • If your primary goal is capital growth and you have a higher risk tolerance, a 40% allocation to government bonds may not meet this objective. Hence, one may consider reducing exposure to government bonds and income-generating assets more broadly to focus on capital growth. Generally, an alternative form of income such as covered call ETFs, which tend to perform better in volatile or sideways tracking markets, could be better suited to increase portfolio income potential.
  • On the other hand, an income-focused investor may want to add to the income-generating portion of their portfolio to get regular passive income (cash flow). Having said this, such a high allocation to one stream of income may leave your portfolio vulnerable to concentration risk – meaning your portfolio’s performance is overly reliant on the success of that particular asset type. As such, it can be beneficial to diversify the type of income-generating assets in your portfolio by incorporating a selection of fixed income, covered calls, and dividends. This works to ensure you have a diversified stream of income that can handle a range of market conditions.

Related Funds

AYLD: The Global X S&P/ASX 200 Covered Call ETF (ASX: AYLD) invests in at-the-money call options written over the S&P/ASX 200 Index.

QYLD: The Global X Nasdaq 100 Covered Call ETF (ASX: QYLD) invests in at-the-money call options written over the Nasdaq 100 Index.

USHY: The Global X USD High Yield Bond ETF (Currency Hedged) (ASX: USHY) invests in high-yield-rated corporate bonds in US dollars by companies domiciled in developed countries.

USIG: The Global X USD Corporate Bond ETF (Currency Hedged) (ASX: USIG) invests in investment grade, USD denominated corporate bonds to offer investors a tool to generate yield from a fixed income asset class.

USTB: The Global X US Treasury Bond ETF (Currency Hedged) (ASX: USTB) invests in US Treasuries across the yield curve while providing currency hedging.

UYLD: The Global X S&P 500 Covered Call ETF (ASX: UYLD) invests in at-the-money call options written over the S&P 500 Index.

ZYAU: The Global X S&P/ASX 200 High Dividend ETF (ASX: ZYAU) invests in 50 high-dividend stocks from the S&P/ASX 200 Index.

ZYUS: The Global X S&P 500 High Yield Low Volatility ETF (ASX: ZYUS) invests in 50 of the highest dividend yielding equity securities from the S&P 500 Index.