Investment returns usually correspond to the risk level, but the holy grail for investors has always been assets with an 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. Many structural products are engineered and designed to look like low risk investments but masking the real risk of investing.
Our investment philosophy is an active and absolute total return approach in finding returns by holding investments in our portfolio, focusing on the immediate income yield and income growth over time.
The active management of investment is not for everyone. Most want to get on with life and therefore want to deploy capital in a passive income stream while minimal fuss. For those who prefer this route, passive investments can be made either through financial advisors or direct investments.
The range of passive income ideas below shows the possible options which can provide a passive income stream. However, only because the investments are passive does not mean they are low risk. It is always essential to understand what the underlying asset does, essentially what you’re buying and the risks it takes to create the income stream and the amount of inherent leverage in the investment, and the risks that come with it. Doing the work beforehand and understanding what you are getting into will avoid the nasty surprises, which always happens more than you think in financial markets.
There are many passive income streams, and these are not recommendations but serve as a starting point for long term investors. We have just a shortlist of the most common and smart passive income investment ideas, but it is by no means comprehensive.
Sources of Passive Income
Dividend Shares
There are two ways of holding dividend shares, directly or through an investment fund. Having a diversified portfolio is critical compared to concentrating all of the capital on just a few companies. Therefore, this approach requires a degree of input and time but can be very rewarding if done correctly.
Investing in a Dividend Share Portfolio
The first port of call is blue chip dividend shares, which has been consistently paying dividends. Investing in shares requires stock selection skills, understanding of business strategies, the financial statement, and emotional strength of riding out the market volatility.
Mistakes always happen in investing but missing any of the skills will increase the chance of making more mistakes over the long run. Losses are inevitable in investing. The goal is to make sure the winners more than offset the losses.
Everyone approach investing differently. We do our research and do not rely on tips from others. As part of our idea generation process, it is essential to read widely to gain various perspectives.
A key distinction in owning shares is that the company earnings do not automatically translate into a future dividend income stream. Dividends are earnings the company board decides to return to shareholders. Management teams can create value if the investment they make using the retained earnings in projects can generate returns above capital cost.
Typically shares that meet the passive investing approach are defensive with a reliable revenue stream rather than companies trying to conquer the world through growth. It cost money to grow, and at the end of the shareholder will be paying for it either through issuing new capital or reinvesting the existing earnings.
As a pure value investor, we see our income stream is not just the dividends but the company earnings. If the management has credibility in creating value, we are not so antsy in asking for dividends and capital invested return. A proven management track record is essential in our share selection process. It is our opinion companies with value destruction management teams are a non-starter.
Investing in Exchange Traded Funds (ETF) for Income
Traditional active management fees in managed funds eat up a large portion of the average stock market returns. ETFs represent a low cost alternative for long term investors and can be used to create a passive income stream.
Not all index funds are listed. An index fund traded on a stock exchange is called an ETF. By listing on the stock exchange, investors can 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 the US market like the S&P 500 (ASX IVV).
1. Equity ETFs
A subsect of equity ETFs listed on the ASX are funds focused just on income called dividend ETFs. These funds select stocks with a higher than average dividend yield and a current dividend yield that is sustainable. Equity ETFs are one of the best passive income streams for those with a long term investment horizon.
Dividend fund’s advantage over single share investment is that it is diversified from inception and offloads the investor’s work to the market.
2. Fixed Income ETFs
Fixed income funds invest in debt securities, and it is called fixed income because the coupon is preset from the onset. If the bond is purchased when initially issued, the long-term return is simply the coupon rate.
In the intervening period, the bond’s value can change over time as the market interest (government bond yields) changes. If the interest rate rises after the bond is issued, the current bonds’ current value can fall. On the other hand, if the interest rate falls, then the bond value issued at higher rates can be worth more. For long-term investors who do not intend to trade, these are only marked to market changes and have no impact on returns if they are held to maturity.
Fixed income ETFs differ from Equity ETF as debt sits higher on the capital stack than equity, which means on a like for like, the risks are lower owning the debt. Similarly, the returns for fixed income ETFs are generally lower than equity dividend ETFs.
A twist to traditional bonds is hybrid securities, which take on aspects of equity and debt. Hybrids rank higher than equity but still sit behind debt in the company’s capital structure. Usually, banks issue these securities as they are counted as equity from a corporate rating perspective and as an alternative capital source for diversification purposes. Because of this, yields on hybrids will be higher than debt to compensate for the additional risk.
Real Estate Passive Income Ideas
1. Listed Property Trusts (LPT) or Real Estate Investment Trusts (REIT)
LPT or REIT invests in commercial real estate such as office, warehouse, logistics, and shopping malls. A mix of equity and debt make up the capital stack of commercial real estate funding, and the REITs listed on the ASX represents the equity component of the capital structure.
Commercial real estate can provide a consistent stream of passive income and a higher rate than residential real estate. Properties in the asset can do this because tenants in commercial buildings sign longer leases and are of better credit, which provides greater consistency and predictability in income.
Investing in REITs has many advantages over owning property directly.
- REITs being listed and being tradable instruments offer greater flexibility in portfolio management and asset class exposure opportunities. Most office buildings are worth multiple individual investor portfolios. It is simply unfeasible for most investors to invest directly in commercial real estate.
- REITs overcomes the size hurdle by allowing the investors to own a portion of the fund that owns the building. Investors can adjust their investments according to their risk profile and portfolio allocation mix.
- REITs are also diversified funds across dimensions from several properties, locations, and in most instances, various commercial real estate asset classes.
- Investors should still carry out due diligence on the fund’s track record and reputation irrespective of the manager’s standing.
2. Unlisted Property Funds
There is also an option of investing in unlisted real estate syndicates, a mix of REIT, and direct property investing. Unlisted real estate offers investors an opportunity to buy into a trust which will only hold a single asset. Most unlisted syndicates provide single asset exposure and potentially higher returns to compensate for the higher risk of putting all your eggs in one basket.
3. 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, holding an investment property directly can be a double edged sword. On the one hand, it provides a higher degree of control as the investor is now in charge of managing the asset, but at the same, it will require a high degree of involvement every month.
Investment loan interest is deductible, providing additional tax benefits if the higher the investor is in the tax bracket.
Bank Cash Accounts and Mortgage Interest
With interest rates at a record low, there is a minimal return from cash sitting in the bank. We see the money held in the bank as an option to take advantage of share market falls.
One practical saving idea over the long run is prepaying the principal residential mortgage. As the saying goes, a dollar saved is a dollar earned. Mortgage interest is a bad debt because the interest payments on the loan are not tax deductible.
A safe option that applies to many is repaying mortgages as a source of passive income. Every dollar repaid today means there will not be interest on the same amount in the future. 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 comes from after tax income. 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%).
The savings is equivalent to an investment with a return of 7.143%. After paying the 30% tax on the profit, the investor will earn 5% after tax.
The critical 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 of compounded overtime. Any investment will have risk, and investors will have to risk the capital to achieve a similar return. 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 principle applies to any non deductible debt, especially credit cards and personal loans, which have 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 critical points, it would limit potential risks in selecting the right investment.
Valuation plays an essential 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 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 of the leverage the underlying investment uses 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. A higher leverage level means equity value is more susceptible to changes in asset values.
Interest rate sensitivity plays a vital role since the income stream’s value; hence asset value fluctuates based on changes to the interest rate expectations. But the impact will not be the same for all assets, with different assets being affected differently. For example, Hybrid securities are mostly immune to a rise in rate because their returns are based on the yield curve plus an interest margin, while the value of fixed rate bonds is more susceptible. On the other hand, returns by pre paying the mortgage will increase the future income the most.