The proliferation of exchange traded funds (ETFs) has resulted in an array of choices in the income area that allow investors to create a high, stable source of income using ETFs alone.
ETFs can be used to access a variety of income products, including traditional government bonds, higher yielding alternatives such as corporate and emerging market bonds, and income-paying equities such as preferred shares, common shares and real estate investment trusts (REITs).
Fund of fund products are also available that provide access to a predetermined mix of fixed-income asset classes with the purchase of a single ETF. Sector-focused products, such as those that offer a selection of dividend-paying stocks in a specific industry such as banks or utilities, are also available. Some of these employ the use of call options strategies to enhance income.
“Income investing through ETFs is one of the biggest trends underway right now,” says Mary Anne Wiley, managing director of Toronto-based iShares Canada, a division of BlackRock Inc. “Income ETFs not only cover bonds, but also certain equity exposures that offer income. If we aggregate all of these income-generating ETFs, they’re generating 60% to 70% of the flows into our products.”
Fixed-income products fuelled the growth of ETFs last year, with $7.1 billion of net inflows, up 54% from the previous year. By comparison, equity inflows were $4.2 billion, up 11%. Total ETF assets in Canada 2012 were $56.4, up 28% from $43 billion a year earlier.
Partly driving the popularity of these products are their relatively low management fees as compared to actively managed mutual funds — a factor that is especially important to investors when yields are low.
Preferred shares and corporate bond ETFs were the most popular within the fixed income category last year, according to a report by the National Bank of Canada. The biggest selling income ETFs in 2012 were BMO Aggregate Bond Index ETF (TSX:ZAG), iShares S&P/TSX Canadian Preferred Share Index Fund (TSX:CPD), BMO Short Corporate Bond Index ETF (TSX:ZCS), and iShares 1-5 Year Laddered Corporate Bond Index Fund (TSX:CBO).
“Income is front and centre with ETF flows,” says Pat Chiefalo, Toronto-based director of derivatives and structured products for National Bank Financial Inc. “Suppliers are pushing out a lot of income products, that go beyond basic bond index exposure and allow for broad diversification. Actively managed ETFs are also available in the income space, as well as passively managed products.”
Toronto-based First Asset Investment Management Inc.’s lineup of 16 ETFs includes some that use call option strategies to increase income, as well as those focusing on specific income sectors such as Canadian convertible bonds, Canadian provincial bonds and emerging markets bonds.
“We gravitate to certain financial instruments and strategies that fit our profile of better risk-adjusted returns,” says Barry Gordon, president. “For example, convertible bonds on average have two thirds of the upside of a typical equity security, and one-third of the downside.”
First Asset recently launched three fixed-income ETF products that employ what Gordon calls “barbell strategies” using a mix of short maturities at one end and long maturities at the other to achieve a combination of yield and reduced duration risk. The barbell ETFs track government bonds, corporates, and a mixed bond portfolio.
“It’s a smart way to own bonds if you’re entering the market now with interest rates near the floor,” Gordon says. “Rates can’t go lower, but they’re unlikely to soar quickly. A balanced risk-adjusted approach like the barbell is consistent with our strategy.”
National Bank has assembled a recommended portfolio of 11 ETFs designed to provide broad diversification and a monthly income amounting to 4% annually. It includes exposure to Canadian, U.S. and foreign dividend-paying stocks, Canadian preferred shares, broad Canadian bond indices, Canadian REITs, U.S. corporate bonds, and emerging market bonds.
This is the third article in a three-part series on the quest for income.