The ultimate guide to picking ETFs for income

Are you struggling to generate enough income out of your investments in the stock market? Are you tired of watching your term deposits dwindle away? 

Well, my friend, step into my (home) office. 

Our recent Income Series survey found that 97.6% of you are invested in domestic equities for income, while 69.4% said they would be increasing their exposure to the local share market over the coming 12 months in their quest for income. 

And yet, more than 72% of you said overvalued stock bubbles were your greatest concern. 

I'm no Einstein, but surely there has to be a more diversified way to generate sustainable and attractive levels of yield in what many of you believe to be a frothy market environment. 

Perhaps, rather than betting it all on the iron ore miners or Big Four banks, investors should look to ETFs - which can provide a diverse range of holdings within equities, bonds, real estate, and credit, as a viable solution. 

Thanks to Michael Wayne of Medallion Financial, you can do just that. In this video and wire, he shares how you can learn to build a boss-level portfolio of ETFs to deliver attractive levels of yields and returns in the current low-interest-rate environment.

And for a little added spice, we will be tracking the performance and yield of his model portfolio over the year to come. 

Note: This interview was filmed on Tuesday 21st September 2021. You can watch the video or read a summary below. 

What are some of investors' biggest pain points when it comes to income? 

Wayne says the typical pain point for investors is the struggle to generate sufficient income out of their investments in the share market, whether that be direct shares or ETFs. This is because, over the last few years, the average income across the board has reduced from around 4-5% to around 3% yield, he says. 

"It is becoming more and more difficult to extract that income to live off day-to-day. That is definitely a pain point for a lot of customers," Wayne says. 

Another pain point is the shift from traditional yield sectors and companies (such as the banking stocks and Telstra) to material producers as being the high yielders (such as the iron ore miners), he says. 

"For us, we tend to avoid being drawn into those sectors too much because we think that they're very cyclical and volatile, as we saw in 2015-16," Wayne says. 

"We do hear many customers that we speak to asking, 'Should we be moving into some of those other sectors that produce the high income, at least in the short term, because we're missing out on the more traditional sectors?' 

But I think investors need to be very careful because the share prices of those companies can very quickly turn to the downside, eroding any oversized income that you might be getting, as we've seen in recent weeks." 

Can ETFs provide an attractive solution for income investors?

Absolutely, says Wayne, noting that while many may associate ETFs with equity markets, there is a range of ETFs that can provide investors with access to corporate bonds and hybrids, for example. 

"If you think about the hybrid ETF managed by Coolabah Capital (HBRD) that's a typical ETF that we use, which helps produce income for clients," he says, 

"Then there are different corporate bond ETFs, high yield ETFs, things like IHCB for instance or IHHY." 

These ETFs can boost the income component of a client's portfolio, and used alongside equity investments, can give them exposure to growth as well as a steady income stream throughout the course of a 12 month period, Wayne says. 

Is there a holy grail income ETF that satisfies both low fees and strong performance?

While Wayne says that "ultimately performance is everything," he does argue that investors should only use passive ETFs with low fees. 

"There's no point just getting broad-based passive exposure and paying high fees," he says.

"However, if you're looking at some of the more active ETFs or some of the ETFs that give you exposure to niche parts of the market, or exposure to products that retail investors usually couldn't get access to, then we're happy to pay higher costs if it means that we're getting that exposure." 

While these ETFs may have higher fees, they can boost returns and increase diversification, and thus Wayne believes they are often worth the cost. 

However, an ETF that satisfies on both low fees and strong performance is the BetaShares S&P 500 Yield Maximiser (ASX: UMAX), an actively managed fund that gives investors exposure to the US. 

"Basically, this gives you exposure to the S&P 500, but they implement a covered call strategy... which helps reduce the volatility but can also increase the yield of that particular investment," Wayne says. 

"That has returned over the last 12 months, something like 25-30% capital growth, but has also delivered a 5-7% yield distribution over the last couple of years consistently." 

Passive versus active when it comes to income

For those looking to generate a passive income stream, Wayne believes it makes sense to stick to passive ETFs.

"That way you can determine what it is you're looking to achieve out of your investments, and the income you need to live off for the next six to 12 months, and then picking an investment portfolio that is able to deliver that steady stream of income for you," he says. 

Investors should also be careful to read the fine print, he adds, as some ETFs will pay out distributions quarterly, while others may do so monthly. Another tip, Wayne says, is to hold these investments for the medium to longer term. 

"From time to time, there will be tactical decisions that you make," he says. 

"There might be a certain policy decision made overseas or a change in central bank attitudes, which might mean you want to reduce your exposure to say high PE/high growth type ETFs and focus more on some value, cyclical type ETFs. 

"But that is probably changing things around the edges, at the margin, if you like, as opposed to making wholesale shifts in strategy, just to get different amounts of income." 

Are there any new entrants that have sparked your interest? And what are you steering clear of?

Wayne and his team have recently been buying Coolabah Capital's new Active Composite Bond Fund, which has the ticker code FIXD, as a way for clients to gain diversification within the fixed income component of their portfolios. 

"It's a long/short fund that takes positions in the fixed income markets, across a number of different spheres," he says. 

"Coolabah Capital have shown themselves to be very good managers over a long period of time and I think this new ETF... is really agnostic when it comes to market moves one way or the other."

Meantime, an ETF he wouldn't be buying at the moment is the Betashares Asia Technology Tigers ETF (ASX: ASIA). 

"That's a thematic that is coming under a bit of pressure at the moment, given what's going on in China and the technology industry over there," he says. 

He also notes that investors who have done very well out of tech ETFs may want to reduce their weightings slightly. 

"You still want to have an overweight exposure to tech, given that the growth is probably very, very strong. But from our standpoint, you might want to rebalance slightly," Wayne says. 

"Take a little bit out of some of those tech-focused ETFs and maybe look for some more cyclical value type ETFs out there just to rebalance your portfolio." 

This is owing to the fact that while the "probability of inflation rearing its head" may not be very high, it is still an increased risk. 

"It makes sense to have more exposure to say, cyclicals, than it does to say, your high growth names," Wayne adds. 

Wayne has very kindly put together a list of 23 ASX-listed products that he would use in an income portfolio to generate sustainable levels of yield and returns in the current market environment. 

These include many of the aforementioned ETFs, including Coolabah Capital's hybrid ETF (HBRD), which Wayne notes has been a good performer in recent years and boasts low downside capture and consistent yield. 

He also lists the Ishares Global High Yield Bond ETF (IHHY), Betashares Australian Investment Grade Corporate Bond ETF (CRED), as well as listed investment trusts such as the Gryphon Income Trust (ASX: GCI), which invests in mortgage-backed securities and delivers consistent yields, Wayne says. 

"The way we tend to look at it is, you want exposure to Australian corporate bonds, you want exposure to international corporate bonds, you want exposure to hybrids, you want exposure to the housing market. And within the different sub-sectors of fixed income or corporate bonds, there are different areas that you want to be exposed to," he says. 

In terms of equities exposures, Wayne has pointed to the VanEck Morningstar Australian Moat Income ETF (ASX: DVDY), a number of LICs from the WAM stable, Cadence Capital (ASX:CDM), the ETFS S&P/ASX 300 High Yield Plus ETF (ASX: ZYAU) as well as several others. 

The largest exposure, the BetaShares S&P 500 Yield Maximiser Fund (ASX: UMAX), makes up 8% of Wayne's ultimate income portfolio. This is followed by the BetaShares Australian Top 20 Equity Yield Maximiser (ASX: YMAX), with a 7% weighting. 

While there are some ETFs that have delivered consistent income for investors, sometimes they fall short on capital growth, Wayne adds. For this reason, Medallion Financial typically invests directly in shares for its clients and uses ETFs for exposures where they do not have a similar level of expertise. 

"You have to understand in Australia that the market is really driven by your banks and your miners," he says. 

"In years like last year, when those parts of the market do very, very well, your high yield ETFs are going to do very well, and not only in terms of capital growth, but income." 

In periods where those particular sectors don't perform as swimmingly, the yield these ETFs may generate may be "okay" but your overall performance won't. 

"For that reason, we tend to focus on stock-specific companies that have the chance not only to deliver consistent income but growing income over time," Wayne says.

Over the past year, Wayne was adding to Sydney Airport (ASX: SYD), and points to Vicinity Shopping Centres (ASX: VCX) as a recent purchase. 

"This is a company where if you're buying it now, today's prices of distribution are around 5.5-6%," Wayne says. 

"However, if income can return between where it is now and where it was pre-COVID, then there's a good chance that based on today's prices, your distribution will be close to 7% or even 10%." 

The wrap up

While there have been many articles penned since the recent August reporting season on the topic of "dividends being back (and with a vengeance)," it seems poignant that these are the exact areas of the market that Wayne believes investors should be wary of when chasing yield.

After all, since the end of July, Fortescue Metals' share price has slid around 40%, while BHP and RIO have suffered a 30% and 26% blow in the same time period, respectively. This has wiped out much (or most, if we are being honest here) of the dividend gains investors would have made over the past year, in a similar vein to what markets experienced with the Materials sector at the end of 2015 and into 2016.

Perhaps a diversified approach to income, one that utilises ETFs for exposure to not only equities markets, but also local and global corporate bonds, the housing market, and hybrids, as suggested in Wayne's model portfolio above, could be worthy of consideration. 

However, as always, the insight and advice shared in this article should be taken with a grain of salt, as it is general in nature and not personalised to your financial wants and needs. Furthermore, it's a good idea to speak with a financial adviser before making any investment decision. 

Why you can’t miss the Livewire Income Series

Livewire’s 2021 Income Series gives investors best in class education and premium content to build a bulletproof income portfolio.

Click here to view the dedicated website, which includes: 

• A list of income-focused ETFs, LICs and funds.
• Detailed fund profile pages, with data powered by Morningstar.
• Exclusive interviews with leading fund managers.
• Videos and articles to help you perfect your income strategy.

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