With bank deposits delivering falling rates of interest, some investors are turning to high-yielding shares in search of higher returns, while still taking risk into consideration. A range of funds management strategies can also produce similar levels of high income at lower risk.
Soaring share prices may attract the headlines but regular, steady income pays the bills.
It’s something that many investors are all too aware of as the Reserve Bank of Australia has cut interest rates in recent years, dampening returns from cash and term deposits.
It has particularly hurt investors approaching retirement or drawing down on a pension – investors who seek the growth offered by shares as well as regular income to fund their lifestyles. It has never been more important as the Federal government plans to reduce the value of the age pension safety net and raise the minimum age to 70 in response to an ageing population1.
More than one million self-managed super fund (SMSF) trustees have already revealed their preferred strategy: invest in blue-chip stocks which pay strong fully-franked dividends and hold a significant proportion of the fund in cash at rates that may only breakeven against inflation, according to this year’s SPAA and Russell Investments Intimate with Self-Managed Superannuation report2.
The big four banks (NAB, ANZ, Westpac and Commonwealth Bank of Australia) and Telstra paid out fully-franked dividends of 4.9-5.8 per cent in 2014, according to JP Morgan3. Those rates are significantly more attractive than online savings accounts paying 2.5-3.5 per cent, according to data from Canstar4 – rates which have been falling in recent years.
But there are a range of investment options which extend well beyond high-dividend paying shares. Professional fund managers employ a range of strategies to generate higher yields on share investments.
For example, they may choose a wider range of high-dividend paying stocks than typically held by an SMSF. It is a diversification strategy which can smooth the ups and downs which affect all share investments over time.
When compared to individual investors, fund managers tend to have access to a wider range of information and greater access to company management.
Another strategy is income-focused exchange-traded funds (ETF). These ETFs own an underlying basket of high-dividend paying stocks and a number have been launched on the ASX since the global financial crisis.
While many income-focused ETFs include a range of both qualitative and quantitative filters, the automatic nature of their stock selection means the risk of falling into a ‘dividend trap’ is greater.
For example, a stock price may fall sharply because the company is facing financial problems, making its historic dividend look attractive. However, those same financial woes may force the company to cut its next dividend payment.
A professional fund manager can bring a subjective, qualitative view to their stock selection compared to an ETF’s quantitative rule-based selection process.
Smart stock selection as part of a more diversified basket of investments is not the only way to generate high-yield returns. Some fund managers use more sophisticated strategies involving derivatives that attempt to generate income and protect against a falling market.
For example, a high-yield fund could sell call options over its share investments. The call options would have a strike price which is out of the money (above the current share price). If the shares rise in value and hit that strike price, the holder of the call option could exercise their right to buy those shares.
Whether the strike price is reached or not, the fund books extra income from the premiums it receives for selling the call options. It is a strategy which can produce a buffer in a falling market (thanks to the extra income on unexercised options) but limits extra capital gains in a rising market (because the option holder is likely to exercise their right to sell the shares).
Learn more about diversifying your investment across other high-yielding strategies at the upcoming ‘Unlocking the value of diversification’ seminars, being held nationally in October. Register for the seminars now.
1. Federal Budget 2014. http://www.budget.gov.au/2014-15/index.htm
2. Intimate with Self-managed Superannuation report by SPAA and Russell Investments. February 2014.
3. JP Morgan Australia Equity Research September 11, 2014.
4. Canstar website accessed September 24, 2014. http://www.canstar.com.au/savings-accounts/compare-online-saver/