This article appeared in the July 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Low-cost exchange traded funds are becoming more popular with income-seekers.

Photo of Drew Corbett By Drew Corbett, BetaShares

The Australian exchange-traded fund (ETF) industry has come a long way in the past two years, with a broad range of exposures now available for the first time. ETFs are an access vehicle, designed to give investors low-cost, efficient and transparent exposure to a range of asset classes.

Almost 80 ETFs and exchange-traded commodities (ETCs) are available on ASX, including several products that enable investors to access yield in their portfolios and with underlying exposures in equities, fixed income and cash.

Recently, BetaShares, with independent researcher Investment Trends, released its annual ETF survey report. A highlight was the significant reduction in investors' capital growth expectations from sharemarkets, which fell from about 8 per cent at the end of 2011 to 4 per cent for the first half of 2012.

When cash products return higher yields than investors expect in the equity markets, while also providing steady income, it is easy to see why term deposits and high-interest accounts have gained popularity. But cash and term deposits are not the only ways to access yield. ETFs offer investors great flexibility to implement different yield-oriented strategies.

Dividends for yield

For investors focused on dividends, it is important to understand that ETFs over equity indices aim to pay the equivalent level of distributions and dividends as the underlying equities (less any management costs).

As dividends flow through to the investor as described above, a popular strategy has been to obtain dividend yields via an ETF. There are four dedicated ETFs on ASX that are focused on dividend yield. The benefit of accessing yield through an ETF is that it provides diversification by holding a range of higher-yielding companies across different sectors.

The four dividend ETFs have different underlying holdings, which can be viewed on the providers' websites, and investors should do their due diligence in selecting the best fit for their portfolio. (Editor's note: you can learn about these dividend ETFs, under Strategy Focussed ETFs).

Another common strategy for yield-based investors is looking at financial sector ETFs on ASX to access yield. In 2011, the financial sector ETFs actually distributed higher dividends than the specific high-dividend ETFs. For example, BetaShares Financial Sector ETF had a gross yield of 9.5 per cent in the 12 months to December 31.

The reason for this outsized dividend return is because the big four banks and other financial companies tend to distribute above-average dividends compared to other sectors. A financial sector ETF provides diversification benefits for investors, so they do not need to take single-bank share risk. They can access the ETF via a single trade.

Fixed income through an ETF

Fixed income refers to the range of investment instruments where there is an agreement between a borrower/issuer to make payments (called a coupon) on a fixed schedule to the lender. Borrowers can range from governments to companies looking for access to capital.

With the introduction of ASX-listed fixed-income ETFs, investors have access to the asset class without the hurdles of large minimum investments or investing in specific fixed-income managed funds.

Seven fixed-income ETFs are available on ASX, ranging from corporate, semi-government and government exposures.

Fixed income has its place in a portfolio as a diversifier and source of regular payments. However, the reality is that many Australian investors have not had direct exposure to fixed-income investing and education is critical.

Editor's note: To learn about the features, benefits and risks of fixed-income investing do the free ASX online course on interest rate securities.)

Bond duration is key

One of the most important concepts associated with fixed income is duration - the measure of how quickly the bond will repay its true cost. Expressed in years, it ultimately indicates how price sensitive a bond is to changes in interest rates. The longer the duration, the more sensitive the bond is to rate movements.

An investor purchases a bond with a face value of $100 and a coupon rate of 5 per cent. The next day, the issuer can only finance debt at 6 per cent and issues the same $100 bond. If the investor had waited a day, they could have purchased a bond that yields a higher coupon rate. Hence the value of the bond with a 5 per cent coupon would be worth less than the bond issued a day later. With the coupon rates determined by interest rates, as interest rates rise the value of the bond decreases.

The example touches on the basics of fixed-income investing and why conducting due diligence on how different products work is imperative.

Although there are more factors to consider, experience, familiarity and understanding will help ensure fixed-income investments provide the right exposure for your portfolio.

Using the cash ETF

Perhaps the most familiar way for investors to access yield is through cash. Before the introduction of the cash ETF, the two main options available for cash exposure were term deposits or "at call" bank accounts.

There can be advantages in term deposits, but investors may also incur break fees or forfeit interest earned if the money is accessed before the maturity date. There are also opportunity costs if, having already locked in a lower rate, interest rates rise or other asset classes outperform.

Compared with term deposits, high-interest savings account give investors greater flexibility and easy access to funds. However, term deposits are likely to give greater returns than a high-interest savings account. Also, although many financial institutions offer special introductory rates for "at call" accounts, they will lapse after a defined period and often revert to RBA-like rates.

Where the cash ETF differs from an "at call" account is the potential to provide higher returns (at the time of writing 4.63 per cent per annum before fees and expenses, compared with a cash rate of 3.5 per cent) while still providing access and liquidity to funds compared with a term deposit. Importantly, the ETF will seek to provide investors with continued high yields, rather than shorter-term introductory rates.

The universe of yield-oriented ETFs has increased substantially as the range of ETFs has broadened. No method is necessarily superior for yield - they just represent different methods, risk profiles and asset classes, and they have their place in a balanced portfolio.

About the author

Drew Corbett is head of investment strategy at BetaShares. He is a pioneer in the global ETF sector and has more than 25 years of financial sector experience in Australia, Asia, Europe and the United States. BetaShares ETFs are Australian domiciled and trade on ASX.

From ASX

Exchange Traded Funds and Exchange Traded Commodities provides more information about the features, benefits and risks of these products.

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