Investors love the idea of assets with a passive income stream without risk. Rarely the market provides a free lunch with high return low risk opportunities. The level of return usually correspond to the level of risk. The lower the risk tolerance means portfolio returns will also be low. 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 approach is an active and absolute total return philosophy. This means that the investments we select for our portfolio focus not just on the immediate income yield but also increasing value of the investment down the track as result of income growth and value created by management.
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 at investors that are looking for sources of consistent income returns. As we mentioned, only because the returns are passive does not mean they are lower risk. It is always important to understand what the underlying asset do and how that income is generated as well as the amount of inherent leverage and risks.
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 means capital loss will be inevitable.
We do our own research in selecting the top stocks in our portfolio and do not rely on tips from others. Everyone approach investing differently. 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. The dividends declared is portion of the company earnings that is distributed to shareholders. Earnings retained will be hopefully reinvested in projects that generate returns above cost of capital.
Since we are pure value investors, we see the income stream as the earning of the company. 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.
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 saving idea is repaying mortgage. As the saying goes, a dollar saved is a dollar earned. Mortgage interest is known as bad debt, which means that the interest payments on the loan is non tax 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 from after tax income. This 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 no deductible debt especially credit cards and personal loans.
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.
Management expenses can make a large impact on long term returns.These funds also have the advantage of being low cost.
There are 2 primary classes of ETFs investors that aims to provide 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.
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 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.
There are also hybrid securities which take on components of equity and debt. The yields on hybrids are higher than debt because hybrid holders sit between equity and debt.
Hybrids will take a loss before debt holders but after current shareholders. Most hybrid securities are also floating rate notes that pays interest at a fixed rate above bank bill swap rate. Interest return 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 REIT a is that it provides greater flexibility in portfolio management and asset class exposure. Most office buildings are worth multiple of individual investor portfolio. It is 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 assets across multiple location and sub asset classes instead of just owing a single asset.
The advantage for those that are looking for hands off investment is that the 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.
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.
Investors should also be aware the leverage the underlying investment uses in order to maintain the current yield. 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.
Avoid direct commodities investment like gold and silver as they do not pay income.