Five ways to generate an income from your investments

One of the key attractions of investments is the potential to earn a regular income, and for many people it’s the number one priority.

There isn’t a one-size-fits-all approach for income investing and product innovation in the asset management industry has increased the choices available to investors.

It’s important to understand the various strategies, how they work, and to whom they might appeal. Here are five of the most popular ones used today.

1. High yield

For decades, investors have looked to investment markets to see if they can find something that offers a better yield than available on cash in the bank. The current benchmark to beat is 5%, being the best-buy savings account rate. That might seem a high bar to clear, yet qualifying opportunities are widespread across stocks, bonds, funds and investment trusts.

The UK stock market is a treasure trove of high yielding stocks thanks to the plethora of low growth, yet highly cash-generative industries. Life insurance, tobacco and property feature heavily, with approximately one fifth of the FTSE 100 offering a prospective yield above 5%.

Investment trusts are also a popular hunting ground, with big yields from companies across the property, renewable energy and debt sectors.

While it is tempting to sit back and let the cash roll in, the income stream only forms part of the returns from an investment. It is important to also look at capital gains or losses.

There’s no point owning a share, trust or fund if you’re consistently losing more money than you make from dividends. Total return is a term that looks at both capital gains/losses and income, and the goal is for that figure to be positive on a long-term basis.

Yields can look high as a result of big share price declines. A falling share price reflects market concerns about something — such as tougher trading conditions or a lack of faith in earnings forecasts. If a company struggles for a long time, it might cut or cancel the dividend.

Just because an investment offers a high yield doesn’t mean that dividend is sustainable — in fact, the high yield could be a red flag. It’s as important to weigh up what could go wrong with an investment as what could go right.

2. Monthly dividend payers

People receive their salary like clockwork throughout their working life. While it’s reassuring to know that money is coming in on a regular basis to cover monthly bills, it can be a shock when someone retires and they no longer have that money topping up their bank account. Investments play a role in replacing that income — either selling small chunks to generate capital or, ideally, using dividends to pay the bills.

Individual stocks typically pay dividends twice a year but that frequency might not suit someone who has monthly bills to settle. An investor could create a portfolio with dividends trickling in across different months. Alternatively, there is a growing number of funds and investment trusts paying dividends monthly to investors.

3. Dividend Aristocrats

While income hunters may judge an investment on its dividend yield, it’s also worth considering dividend growth.

The cost of living typically goes up each year so it’s important that dividends grow at least in line with inflation to ensure you maintain spending power. The ability of a company to grow dividends each year can also be a sign it’s a high-quality business.

There are two ways to quickly identify investments with dividend growth. One is to look at investment trusts classified as ‘Dividend Heroes’ which are names that have consistently raised their dividends for at least 20 years in a row, including F&C Investment Trust and City of London Investment Trust.

The other is to look at tracker funds labelled as ‘Dividend Aristocrats’. This is a term to describe companies with a long record of raising their dividend each year, often by 25 years or more. The term will appear in the fund name, or sometimes you might see a variation such as ‘Dividend Leaders’.

There are various ETFs which track a basket of companies classified as Dividend Aristocrats in Europe and the US.

Not all investors need to take the income from their investments and they might choose to reinvest any dividends to enjoy compounding benefits. The prospect of owning an investment that aims to deliver consistent dividends or even dividend growth — such as Dividend Aristocrats – might appeal to them.

4. Enhanced income

Income-hungry investors are often happy to receive the bulk of their returns from dividends rather than capital gains. There is a specific type of fund that might appeal to this type of person.

Enhanced income funds (also known as ‘income maximiser’ funds) have a clever trick up their sleeve to boost their dividend power. They might generate a 4% or 5% yield from their underlying portfolio but have a neat way to pay even more to investors.

They sell call options on stocks held in the portfolio to generate additional income. These options are contracts that give the buyer the right, but not the obligation, to buy the underlying asset at a specific price on or before a certain date.

For example, an investment bank buys an option on Company X from an enhanced income fund for a fee. This entitles the investment bank to any rise in the price of the underlying share above a certain level over a set period, typically three months. The enhanced income fund uses the option fee to top up its dividends, but in doing so it sacrifices part of the capital growth from the stock holding.

Enhanced income funds might underperform traditional equity income funds when markets are rising but potentially outperform in a falling market.

Call options can be difficult to understand and charges on enhanced income funds are often much higher than a traditional equity income fund. That means these types of funds won’t suit everyone.

5. Blending income and growth

The blended approach of income and growth is increasingly popular with investors who want a happy medium of dividends and capital gains.

Someone in retirement looking to make their pension last longer might use this approach. So might an individual who wants their investments to grow and use cash from dividends to fund additional investments down the line.

Learn more about how to invest for income