Investment returns usually correspond to the level of risk but the holy grail for investors has always been assets with easy passive income stream while taking low risks. Rarely the market provides a free lunch and generally follows the trend that high risk means high returns. There are many structural products that are engineered and designed to look like low risk investments but really 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 the value of the bussines grows overtime as well 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 and therefore just want to deploy capital in a passive income stream while minimal fuss. This is done either through financial advisors or direct investments.
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. For every investment, 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. This is to avoid any nasty surprises which seems to always happen more than you think in financial markets.
The short list of ways to generate passive income 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.
Sources of Passive Income
Individual stocks through regular dividends but this requires stock selection and for any prudent investor this require understanding of the company’s business strategy, the financial statement and emotional strength of riding out the market volatility. Missing any of these factors means there is a good chance there will be capital losses in the long run. While this is unavoidable, you just need to make sure the winners more tan make up off the losses.
Everyone approach investing differently. We do our own research in and do not rely on tips from others. As part of our idea generation process it is important to read widely to gain various perspectives.
A key distinction in owning shares in companies directly is that the company earnings does not automatically translated to a dividend income stream. 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.
Usually stocks that meet the passive investing approach are defensive in nature that has a reliable revenue stream rather than companies that are trying to conquer the world through growth. This is because growth cost money and any profits usually is required to be reinvested in the business rather than returned to shareholders.
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 return of capital invested. 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.
Diversification Benefit from a Share Portfolio
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.
Exchange Traded Funds (ETF)
Exchange traded funds are just like index funds except while not all index funds are listed, the definition of an ETF is that it is listed on a stock exchange. By listing on the exchange, investors are able to purchase and sell the units when markets are open and can have immediate liquidity on the investment. ETF or index funds are one step up from owning a portfolio of single stocks as most index funds track the equity market like the ASX 300 market index in Australia or US market like the S&P 500 (ASX IVV).
An additional advantage of the ETFs is its low cost and perfect for long term investors as traditional active management fees in managed funds eat up a large portion of the average stock market returns.
There are two primary types passive income investments using ETFs.
1. Equity ETF
A subsect of equity ETFs listed on the ASX this are funds that are focused just on income called dividend ETFs. These funds select stocks which have higher than average dividend yield but also making sure that the current dividend yield is sustainable. This can be one of the best passive income streams for those with a long term view.
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 which follows a specific benchmark that changes overtime.
2. Fixed Income ETF
Fixed income funds invest in debt securities. It is called fixed income because the underlying bond’s coupon are fixed for the duration of the issuance term. If bonds are held to maturity, the return will be simply the coupon rate on the bond and the principal is repaid at maturity.
In the intervening period, 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 fall. On the other hand if the interest rate 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. Usually banks issue there securities are they are counted as equity from a corporate rating perspective and diversify their funding sources. Because of this yields on hybrids will be higher than debt to compensate for the additional risk.
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.
These assets are financed by equity and debt. Current REITs listed on the ASX invests represent the equity portion of the capital structure.
The advantage of investing in REIT vs direct property is that it provides greater flexibility in portfolio management and asset class exposure. Most office buildings are worth multiple of individual investor portfolio and it is simply unfeasible for a large portion of the investor class to invest directly in commercial real estate assets.
REITs overcomes this by allowing the investors to own a portion of the fund that owns the building and the total position size is up to individual requirements or portfolio allocation. REITs also allows diversification across a portfolio of properties, over multiple locations and in sub asset classes rather than just owning 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. Investing in Investment Property – Real Estate Passive Income
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 is a double edged sword where on one hand there is a higher degree of control it will also require a degree of involvement by the owner. This sometimes can be offset by appointing a property manager.
Investment loan interest are deductible which provides additional tax benefits if the higher the investor is in the tax bracket.
Bank Cash Accounts and Mortgage Interest
With interest rates at record low, there is minimal return from cash in the bank. The way we see cash in a portfolio is that it provides option to take advantage in share market falls.
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 are not 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. The return from 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%/(1-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 and one of the best passive income strategies list.
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.
How to Avoid Common Investment Mistakes
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 passive income opportunities to ensure income certainty / 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 least 80% minimum.
Debt investments like bonds and hybrids are unlevered investments are they make up a portion of the capital structure. 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 largely immune to rise in rate because its returns are based on the yield curve plus an interest margin while bonds are extremely sensitive. On other hand, returns by pre paying the mortgage actually increase the future passive income.