Term deposits offered by Australia's banks have enjoyed staggering inflows that now total billions of dollars.
Investors, particularly retirees, have not only been attracted to the relatively high yields of around 6 per cent, but also to the safety and and capital protection of these products.
Longevity, however, has challenged the notion of whether "safe" assets such as cash will meet the income needs of retirees in the future.
The good news is people are living longer. The challenge now is to invest in assets that will ensure money goes the distance.
Some investment managers argue that shares will provide investors with sufficient income that will meet their retirement needs.
Thanks to our franking credit system, Australian shares have delivered attractive dividend returns.
According to MLC Investment Management strategist Michael Karagianis, the average dividend yield of the Australian sharemarket was around 5 per cent at the start of 2012. This return was further boosted to 1.5 to 2 per cent due to the franking tax benefits.
The higher-yielding sectors of the local market are now offering dividend yields of 7 to 8 per cent, or 9 to 10 per cent after franking credits.
BlackRock investment strategist James Holt notes that over past 40 years, dividend growth was the single largest contributor to the Australian stockmarket.
There are a number of equity income strategies that tap into higher dividend yields. BlackRock's Holt says these include:
1) a passive strategy that collects or reinvests the income on an index,
2) an approach based on investing in above-average yielding stocks with the objective of generating long-term superior returns,
3) investing in companies that have a better-than-average starting yield and increase their dividend payments faster than the market over time,
4) and active management of a portfolio with the objective to generate income.
Morningstar co-head of research Tim Murphy says there are a number of products available to investors that are consistent with these strategies.
1. A passive strategy that reinvests the income on an index
Murphy says investors can find this strategy in the high-dividend exchange-traded funds (ETFs) that are currently on offer.
These include the Russell High-Dividend Australian Shares (RDV), the iShares S&P/ASX High Dividend (IHD) and the SPDR MSCI Australia Select High Dividend Yield Fund (SYI). These ETFs all track indexes that invest in high-dividend stocks.
Murphy says investors need to consider the different fees for each of these products, as well as the indexes they track. For example, the SYI has a greater weighting to financial stocks compared to the RDV, which has a greater exposure to real estate investment trusts and material stocks.
2. Investing in above-average yielding stocks with the objective of generating long-term superior returns
Murphy says value managers tend to adopt this strategy. These managers generally view dividends as a key growth driver in the market.
A value manager like Tyndall, which manages the Tyndall Australian Share Portfolio [3986], invests in a company according to range of valuation criteria, including dividend yield as well as price/earnings, enterprise value, EBITDA (earnings before interest, taxes depreciation and amortisation) and operating accruals.
The Investors Mutual Australian Share Fund [5339] is another value-based fund that has a preference for high-dividend paying companies.
3. Investing in companies that have a better-than-average starting yield and increase their dividend payments faster than the market over time
Murphy notes these strategies tend to adopt a combination of growth and value approaches to investing in stocks.
The Grant Samuel Epoch Global Equity Fund [16302] is an example of a fund that fits such a strategy. The fund manager focuses on a company's cash flow. The investment team is also attracted to companies with sustainable and growing dividend yields.
Unlike Tyndall and Investors Mutual, Epoch is an international fund manager that scours the globe looking for companies that deliver strong cash flow as well as good dividends.
This may be surprising given the Australian sharemarket is traditionally known to deliver higher dividends than global markets.
BlackRock's Holt says by investing in global stocks, investors have the opportunity to diversify their yield.
"The Australian market is dominated by a handful of banks that are providing the bulk of dividend yields. But there are a whole bunch of sectors globally that are giving investors capital as well as dividend growth. These include the consumer, healthcare and telecommunications sectors," Holt says.
Despite the subdued outlook for growth, Holt says companies around the globe are in a position to increase their dividends.
"Companies have plenty of room to increase dividends because they are currently paying out a low percentage of earnings," he says.
"Recent trends confirm US companies have been raising dividends and we believe the best value for capital appreciation are companies with strong cash flows that have the ability to raise dividends."
4. Active management of a portfolio with the objective to generate income
Murphy says this approach can be found in all active managers who have an income objective in mind.
Both Tyndall and IML run income-focused funds. The Tyndall Australian Share Income Fund [16966]invests in around 40-70 stocks and aims to provide tax-effective income as well as capital growth.
The Investors Mutual Equity Income Fund [12285] is also a tax-conscious fund that focuses on income-generating stocks. There are of course other fund managers that adopt similar strategies. These are just two examples.
A caution on yield
MLC's Karagianis says the key advantage of dividends over cash and bonds is that dividends tend to grow over time in line with corporate profitability.
"This growth provides some natural inflation protection for investors," Karagianis says.
Karagianis cautions, however, that investing in high-dividend shares may not protect your capital.
"While dividends yields are attractive, the capital volatility has also been high. The Australian banks have displayed significant volatility in recent years, despite their high dividend yield," he says.
According to Murphy, investors should not be preoccupied with yield. They should also look at the total return of their portfolio.
"Higher yield can also mean higher risks. Investors have to always remember that the old rule of diversification still applies," he says.
This report appeared on www.morningstar.com.au
2012 Morningstar Australasia Pty Limited
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