Investment returns usually correspond to the level of risk but the holy grail for investors is always assets with a passive income stream with lower than expected risk. Rarely the market provides a free lunch with high return low risk opportunities. There are many structural products that are engineered and designed to look like low risk investments but are instead masking the real risk of investing.
Our investment philosophy is an active and absolute total return approach in finding returns. This means that the investments in our portfolio focus not just on the immediate income yield but are businesses with the underlying value that is compounded at a decent clip as result of value added by the management team.
Alternatively, not everyone can take an active approach in portfolio management. Most just want to get on with life.
We have outlined below a range of passive income ideas that are aimed for those that would want a passive approach to investment however only because the returns are passive does not mean they are low risk. It is always important to understand what the underlying asset does, essentially what you’re buying and how that income is generated as well as the amount of inherent leverage in the investment and the risks that comes with it.
The selections are not recommendations but presents a range of options designed for long term investors that does not necessarily have the skill set to actively managing the portfolio on a daily or monthly basis. These asset classes applies to both superannuation funds and investment portfolios outside of super.
Sources of Passive Income
Individual stocks can provide a passive income stream however stock selection means investors need to understand the business strategy, the financial statement and emotional strength of riding out the market volatility. Missing any of these 3 factors will result in capital loss in the long run. Usually stocks that meet the passive investing approach are defensive stocks that has a reliable income stream rather than companies that are trying to conquer the world by betting all on one product.
Everyone approach investing differently. We do our own research in selecting the top stocks in our portfolio and do not rely on tips from others. As part of our idea generation process, we read widely to gain various perspectives.
Stock’s passive income stream is the dividends. It is important to note that stockholder income and company earnings are not the same. Company earnings is what the company made. Dividends are the portion of the company earnings that is distributed to shareholders. Value adding management will invest the retained earnings in projects that generate returns above cost of capital.
To us as pure value investors, we see the income stream as the company earnings rather than the declared dividend. If the management has credibility in creating value then we are not so antsy in asking for dividends and capital return. We see management track record as a critical criteria of stock selection. We rarely invest in companies where management has a track record of doing value destruction deals.
A portfolio of shares is critical rather than concentrating just on a few companies. Therefore this approach does require a degree of input and time but if done correctly can be very rewarding.
Bank Cash Accounts and Mortgage Interest
With interest rates at record low, there is minimal return from cash in the bank. It does have one advantage of immediate liquidity to take advantage of market pull backs or unforeseen payment requirements.
One effective saving idea over the long run is repaying mortgage ahead of schedule. As the saying goes, a dollar saved is a dollar earned. Mortgage interest is known as bad debt because the interest payments on the loan is non tax deductible. Investment loan interest are deductible.
A safe option which applies to many is repaying mortgage as a source of passive income. Every dollar repaid today means there will not be interest on the same amount going forward. Return on paying off the mortgage can be quite competitive in the current low interest rate environment.
For example if your interest rate is 5% which is paid using after tax income means the equivalent investment return required will be = (5%/Marginal Tax Rate). If the investor is in the 30% marginal bracket the same formula will be (5%/0.7 = 7.143%).
An investment with return of 7.143% and paying the 30% tax will net the investor 5% which is equivalent to the interest on the mortgage.
The important advantage of repaying the mortgage from the example above is that the investor is effectively earning a 7% return at a risk free rate with the benefit simply compounded overtime. Remember investors have to take risks to achieve similar return on investments and in most instances will put principal at risk. Paying off the mortgage is as risk free as you can get.
Note we used mortgage payments as an example but the principal applies to any kind of non deductible debt especially credit cards and personal loans which has even higher interest rates.
Exchange Traded Funds (ETF)
Exchange traded funds are just like index funds except all ETFs are listed on the stock exchange. By listing on the exchange, investors are able to purchase and sell the units when markets are open and can provide immediate liquidity. ETF or index funds are one step up from holding a portfolio of single stocks as most index funds track the equity market like the ASX 300 market index in Australia or US equities like the S&P 500 (ASX IVV). The funds invests in the equity portion of the capital structure.
An additional advantage is its low cost where management expenses can make a large impact on long term returns.
Listed ETFs also allows individuals exposure to alternative income asset classes in which we have highlighted 2 examples below. Both are targeted to investors that are looking for a consistent income return.
1. Equity ETF
Unlike traditional index funds which weight the stock allocation in the portfolio by market capitalization. Listed dividend exchange traded funds uses the dividend yield as the key criteria in stock selection.
Dividend funds has an advantage over single stock with it being a diversified portfolio of securities and off loading the work from the investor to the fund. Key question investors have to ask when looking at the fund is are the dividends paid by the securities funds sustainable and the potential risk to the invested capital.
2. Fixed Income ETF
Fixed income funds invest in debt securities. It is called fixed income because the returns are fixed at the time of bond issuance. If investors own the debt through the life of the bond, the income return is the coupon and they will receive back the principal if no default occurs.
The value of the bond can change over time as the market interest (government bond yields) changes. If interest rate rises after bond is issued, then the current value of bonds can decline. But if interest falls then the value of the bond issued at higher rates can be worth more. For long term investors that do not intend to trade then these are only mark to market changes only and have no impact on returns if they are held to maturity.
A twist to bonds is hybrid securities which take on aspects equity and debt. Hybrids rank higher than equity but still behind debt in the company’s capital structure. Therefore yields on hybrids are higher than debt to compensate this as well as allowing the company diversify its funding source.
In addition hybrid securities are also floating rate notes that pays interest at a fixed rate above bank bill swap rate which provides a hedge against rising interest rates. The interest increases inline bank bill swap rate increases.
Real Estate Passive Income Ideas
1. Listed Property Trusts (LPT) or Real Estate Investment Trusts (REIT)
LPT or REIT invest in commercial real estate including office buildings, warehouse and logistics centers as well as shopping malls. Income stream of commercial real estate are consistent and in most cases higher than residential real estate. Tenants in commercial buildings are typically in long leases which ensure a greater consistency and predictability in income.
The advantage of investing in REIT verses direct real estate is that it provides greater flexibility in portfolio management and asset class exposure. Most office buildings are worth multiple of individual investor portfolio which makes it unfeasible for a large portion of population in investing in commercial real estate directly.
REITs overcomes this through allowing the investors to own a portion of the fund that owns the building and the total position size is up to individual requirements. REITs also allows diversification across a portfolio of properties, over multiple locations and in sub asset classes instead of just owing a single asset.
The advantage for those that are looking for passive investment approach to real estate is he fund will also be managed by a professional fund manager with experiencing in asset management. However the investor should still carry out due diligence on the track record and reputation of the fund.
2. Direct real estate assets
If there is a large sum to be invested sometimes it pays to own the asset directly. We are cautious on residential real estate where record low interest rates have raised Sydney house prices to record high. However by owning the property directly means that there will a degree of involvement by the investors or paying a a property manager to manage it. The key criteria is nothing is ever passive and hands off. If there is issues with the property or the tenant it will require degree of involvement from the investor.
Investment Pitfalls to avoid
Investors should be aware of common pitfalls in chasing yield. By being aware of these key points, it would limit potential risks in selecting the right investment.
Valuation plays an important role in determining the long term returns. These asset classes provide a steady passive for the investor however investors should note that the yield they entered the investment usually locks in medium term return. Hence it is important to diversify across multiple streams to ensure income stability.
Investors should also be aware the leverage the underlying investment uses in order to maintain the current yield. For example listed REITs are rarely above 50% leveraged but it is common to see direct residential investments start at 80% minimum. Hybrids provide comparable long term returns with no leverage. Higher leverage level means equity value is more susceptible to changes in asset values.
Interest rate sensitivity plays an important role as well since most assets above are priced off the interest rate yield curve. Changes in market expectation in interest rate would have a large impact on the value of the underlying asset. Different assets would be impacted differently from changes in rate. For example Hybrid securities are immune to rise in rate because its returns are based on the yield curve plus an interest margin while bonds are extremely sensitive. On otherhand, returns by pre paying the mortgage actually increase the future passive income.
Above all avoid direct commodities investment like gold and silver as they do not pay income.