Australian investors have long looked to dividends, cash and term deposits for income. But income investing no longer needs to stop there.
ETFs can provide access to a wider mix of income sources, each with different characteristics, risks and roles in a portfolio. A simple way to think about them is in four broad groups:
- Equity income, including dividends and the potential benefit of franking credits.
- Covered calls, where strategies such as covered calls can generate income from share portfolios in a different way.
- Alternative income, including royalties linked to assets such as intellectual property, resources or licences.
- Cash and fixed income, which can provide a more defensive income layer through money market instruments and investment grade bonds.
Understanding these categories can make income investing more like a toolkit. The goal is not simply to find the highest yield, it’s to understand where the income comes from, how reliable it may be and what risks are involved.
The income Australians know best
Dividends remain one of the well-known sources of investment income in Australia. When a company earns a profit, it may choose to return part of that profit to shareholders as a dividend.
This can be attractive in Australia, where many listed companies have historically paid a relatively high proportion of earnings. Some dividends may also come with franking credits, which can improve after-tax outcomes for eligible shareholders.1
The challenge is that not all high-yielding shares are equal. A very high yield can sometimes be a warning sign, particularly if it reflects a falling share price or an unsustainable dividend. This is often called a “dividend trap”.
Dividend ETFs provide access to a basket of dividend-paying companies rather than relying on a handful of individual shares. Betashares HYLD S&P Australian Shares High Yield ETF aims to provide exposure to 50 Australian companies with high forecast dividend yields, while screening out potential ‘dividend traps’ such as companies projected to pay unsustainably high dividend yields, as well as companies that exhibit high levels of volatility relative to their forecast dividend payout.
How covered call strategies can generate income
Another way ETFs can generate income is through a covered call strategy.
This involves holding a portfolio of shares and selling call options over those shares. In return, the fund receives option premiums, which can be paid out as income.
There is a trade-off. The fund gives up some of the potential upside if share prices rise strongly. In simple terms, you may receive additional income, but may not participate fully in a sharply rising market.
This type of strategy can be useful when markets are relatively steady, because option premiums can add to income even when share prices are not moving much. However, if markets rise strongly, the fund may not capture all of that growth.
Betashares offers exposure to covered call strategies including Betashares YMAX Australian Top 20 Equities Yield Maximiser Complex ETF and Betashares UMAX S&P 500 Yield Maximiser Complex ETF . These funds use covered call strategies over Australian and US equities respectively.
Alternative income through royalties
Royalty income is generated when the owner of an asset allows another party to use it in exchange for payment.
That asset could be a music catalogue, a pharmaceutical patent, a mining royalty, a technology licence or another form of intellectual property. The owner receives a payment stream without necessarily needing to operate the underlying business directly.
Royalty companies can be attractive because they often have relatively high margins, low capital expenditure needs and exposure to long-term contractual or usage-based revenue streams. They can also provide diversification because their income drivers may differ from those of traditional dividend-paying companies.
Betashares ROYL Global Royalties ETF gives access to a portfolio of global companies that earn revenue from royalty income, royalty-related income and intellectual property income.
Looking beyond equity markets
Not every part of an income portfolio needs to come from shares.
Cash-style investments can provide a more defensive income layer. These assets may produce lower growth than equities, but they can also help reduce portfolio volatility and provide more predictable income.
Money market investments include short-term instruments such as bank bills, negotiable certificates of deposit and other high-quality cash-like securities. They are commonly used by institutions to manage liquidity.
Betashares MMKT Australian Cash Plus Active ETF provides exposure to cash and high-quality short-term money market securities, with income paid monthly.
For those comfortable taking more risk than cash, investment grade bonds can provide another way to earn income. These bonds are issued by governments, companies and banks, and typically pay regular interest in exchange for lending them money.
Enhanced bond strategies seek to increase that income by using internal gearing. Put simply, gearing allows a fund to hold a larger exposure to income-producing bonds than it otherwise could. This can increase income potential, but it can also increase losses if markets move against the fund.
Betashares ECRD Australian Enhanced Credit Income Complex ETF is designed to provide monthly income from investment grade Australian fixed income securities, with yields enhanced through gearing. Because gearing adds risk, ECRD is a more advanced strategy and may suit those who understand the risks involved.
Bringing the toolkit together
No single income source is best in every environment.
Rather than relying on one income source, a portfolio can combine several. A portfolio that draws income from dividends, options, bonds, cash, royalties and credit may be better positioned than one that depends on a single asset class or market condition.
Understanding these options can help you ask better questions, make more informed decisions and feel more in control of how your money is working for you.
