Passive income investing goes beyond chasing high yield
It is a well-known industry phenomenon in Hong Kong that most investors choose their income funds mainly by comparing the marketed monthly payout yields. But besides the headline yield numbers, are there other factors you should consider when picking your income funds?
In this article, we would like to share with you how Endowus Investment Office selects our Best-In-Class income funds, and how you can make use of the same principles and thought process when choosing your own income funds appropriate for your needs and preferences — either through Endowus Fund Smart or elsewhere. As a spoiler, yes — there is more to consider beyond the headline yield, but let’s start from the basics.
What is an income fund?
An income fund is an investment vehicle (typically a unit trust or an ETF) with an investment mandate prioritising returns in the form of cash payments from its underlying investments. This will be in the form of coupons for fixed income funds or dividends from equities funds.
Types of income funds
Income funds can have different investment mandates, leading them to invest in different underlying assets or asset classes. The following type of funds may be considered as an income fund:
- Money Market Funds
- Fixed Income/Bond Funds
- Equity Dividend Funds
- REITs Funds
Appeal of income investing for passive income
As the payouts from the income funds are regular, passive investors just need to commit to an initial capital or investment, and do an initial due diligence of choosing the appropriate income funds. The dividends earned from the funds later on will be a form of "passive income" as there is no active management or efforts put in.
What are the fund selection criteria for income funds?
We have summarised the key criteria in 3 “C”s when selecting an income fund, and they are: Investment Capability, Payout Consistency and Cost.
1. Investment capability of the fund manager
Investment capability is always the most important thing when selecting any actively managed funds. It provides investors the conviction that the fund is in good hands, and will run its course in line with stated objectives and deliver its expected returns and risk. Assessing a fund manager’s investment capability involves both quantitative and qualitative analysis.
For quantitative analysis, it starts with an understanding of the fund’s objective. In this case, one should be looking for funds that have clear income objectives. Usually, different funds target different levels of outperformance against different reference benchmarks given a set level of risk budget, so quantitatively investors should compare the fund’s historical performance and risk against the reference benchmark and see whether it has fulfilled what it set out to achieve. It is true that past performance is not an indicator of future performance, but for an actively-managed fund, if it is consistently unable to deliver its performance target, the underperformance casts doubt on the capability of the investment team.
But one should indeed look beyond just numbers and gain an understanding about the investment team and investment process of a fund. For qualitative analysis, the average tenure, turnover and size of the investment team shed light on how committed and well-resourced the team is to the fund. Characteristics of a good fund are that it has a deep bench of portfolio managers and analysts that are with the strategy for a reasonably long period of time, and that they have an effective pattern of exchanging ideas and collaboration. Recent team shuffles and portfolio manager changes would be a red flag to check further on.
The investment process then helps us understand how investment decisions are made. Generally, funds with a structured investment process would be preferred; examples of this include the use of a common research template amongst analysts, the use of a quantitative scorecard, and a disciplined downside risk management process. These defined steps usually greatly removes key man risk — meaning high decision-making dependency on one key person — and ensures that the investment process is repeatable and the investment philosophy can be coherently exercised by everyone in the team.
Learn more: Endowus Hong Kong partners Best-In-Class fund managers
2. Consistency and source of payouts
An additional dimension of assessing income funds is their payout consistency, both historically and on a forward-looking basis. This is achieved by selecting funds that have been able to deliver a stable payout, and can sustain their payouts going forward. Related to this, it is really important to make sure that one understands the payout structure of the fund.
In particular,
1. Does the fund pay out of capital?
2. Is the payout on a gross or net of fee basis?
3. What is the frequency of the payout?
4. Does the fund pay a fixed or variable percentage or amount?
The first question above is perhaps the most important one, while the remaining questions ensure that investors set the right expectations of where the fund-level cost is deducted (before or after distributions), when to receive the income stream, and the level of fluctuation of the income stream.
A fund can either just pay the dividend or coupon collected from the underlying investment, or supplement these with capital gains, or sometimes even the principal (the capital from investors). The rule of thumb when deciding what sources the fund is using to pay investors can be illustrated in 4 different scenarios:
Scenario 1:
If annual payout > annual total return, then the fund is paying out of dividend/coupon, capital gain and principal investment. This is a decumulating share class of an income fund.
Scenario 2:
If dividend/coupon yield < annual payout < annual total return, then the fund is paying out of yield and capital gain.
Scenario 3:
If annual payout ≤ dividend/coupon yield, then the fund is paying out of dividend/coupon only. For scenarios 2 and 3, the income funds are distributing share classes of income funds.
Scenario 4:
If the dividend/coupon yield is reinvested into the fund’s assets, then it is an accumulating share class of an income fund and there are no distributions unless an investor decides to redeem partial units as a form of payout.
It is generally fine if the fund is supplementing the payout with capital gains, but it would be worrying if the fund continuously supplements the payout using principal, because essentially the fund is paying the investors with their own money. One way to check this is to look at the historical NAV (net asset value) of the fund, and see whether it has been increasing (Scenario 3), stable (Scenario 2), or decreasing (Scenario 1), assuming no major drawdowns in the underlying assets.
3. Cost of fund — fund management fees and platform fees
Finally, a key, but often overlooked criteria when selecting funds is the cost of the fund. The cost of the fund comes in different forms, and depending on where you purchase the fund from, it would include the upfront sales charge, the total expense ratio of the fund, and embedded in the total expense ratio: commissions that one pays to the distributor called trailer fees.
One should always strive to build a low-cost portfolio as much as possible for the simple reason that costs eat into one’s return. An extra 1% of cost per year on an income fund means that one gets 1% less income annually, and this amounts to a significant amount over a period of time.
Learn more: Unit trust investing in Hong Kong: The pains of trailer fess
How can Endowus help?
The biggest challenge when selecting funds is information asymmetry — retail investors have access to a lot less information compared to large institutions and the fund managers themselves. Usually the key reference materials for a retail investor are fund factsheets, Key Facts Statements (KFS) and the prospectus.
Outside of these regulatory documents, and perhaps a few free but simplistic fund comparison websites, there is virtually no free resources left. We believe that investors should not make blind decisions based on limited information, so our Investment Office has taken on the role of an institutional investor on behalf of our clients to conduct holistic due diligence on fund managers and funds, equipped with multiple databases and direct access to fund managers.
Additionally, Endowus has pioneered in lowering the cost of investment to the best we can. There is no upfront sales charge, and we rebate 100% of the commissions for distributing funds (trailer fees) back to our clients, so that they can enjoy the lowest cost possible. Endowus also provides access to institutional share classes of funds — typically only large institutional investors such as endowment funds can enjoy such low-cost share classes, but Endowus has made it possible for retail investors to access through our platform.
Learn more: Introducing Endowus Fund Smart — access top-rated funds and curated model portfolios in Hong Kong
Selected income funds on Endowus Fund Smart in Hong Kong
Endowus has a range of income funds available on our Fund Smart platform, in HKD and USD, at the lowest cost possible. Below are a few ideas for you to get started:
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Risk Warnings
Investment involves risk. Past performance is not an indicator nor a guarantee of future performance. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested.
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