With the RBA cash rate set at just 0.10%, and according to RBA governor Philip Lowe, staying at that low level until 2024 at the earliest, earning a decent income from bank term deposits is impossible.
I am routinely asked for alternative investment opportunities to letting your money effectively rot in the bank.
I'm a stock market person, so will focus on using shares and funds as an alternative.
There are other alternatives, including investment properties, although I will note, like shares, they do involve a level of risk, including debt financing, vacant rental periods, rates, insurance, maintenance costs, not forgetting house prices can go down as well as up!
Back to shares, and some ground rules for this strategy…
History has shown the odds of a positive capital return from the stock market dramatically increase the longer the holding period. So before even considering moving money from the safety of a term deposit to shares, do so only with money you do not need to touch for at least five years, ideally longer.
Commit now to not selling stock market investments during periods of extreme volatility, no matter how scary they may be. Similarly, in a rising market, unless you need the money, resist the urge to sell simply to lock in a profit.
Diversification is absolutely critical. You can achieve that by investing in 20 to 30 individual stocks, or by investing in a few diversified managed funds and/or exchange-traded funds (ETFs).
Unlike term deposits, your capital is at risk when invested in shares. But the longer you extend your investing timeline, the better your chances of capital appreciation.
With all that said, my simple yet incredibly effective way to generate term-deposit busting income from the stock market is to buy one quoted fund, my choice being the Vanguard Australian Shares High Yield ETF (ASX: VHY).
The ETF invests in many of Australia's largest quoted companies, its three largest positions being ASX 200 stalwarts BHP Group Ltd (ASX: BHP), Commonwealth Bank of Australia (ASX: CBA) and Wesfarmers Ltd (ASX: WES).
According to the ASX website, the ETF pays quarterly distributions, and yields, on an annual basis, 2.94%. The level of franking credits will vary, but currently stand at 92%, so its distributions are not far off being fully franked.
According to the Vanguard website, over the past five years, the EFT has delivered a total return of 8.5% per annum.
Why the Vanguard Australian Shares High Yield ETF?
- Management fees are low at just 0.25%.
- Historically, the fund largely tracks the return of its benchmark. Because it invests in a diversified portfolio of some of Australia's largest blue-chip stocks, it is less risky and requires less maintenance than investing in individual shares.
- For income-focused investors, quarterly franked distributions are attractive.
- Pay $0 brokerage when buying ETFs using online broker Superhero.
A 2.94% yield may not sound overly attractive, especially given the additional risk you are taking investing in shares versus a no-risk term deposit.
But, when you take into account the franking credits, the grossed-up yield from the distributions increases to 4.1%, something that compares favourably to "the good old days" when term deposits might have earned 5%, before tax.
If all goes to plan, a $100,000 investment would generate around $3,000 income per annum, and in five years time, assuming capital appreciation of say 5% per annum, the initial investment would be worth around $125,000.
What could go wrong?
- Capital loss. Even after 5 years, there's a chance the stock market, and therefore the Vanguard Australian Shares High Yield ETF, could be trading lower than today.
- You find you do need the money and have to sell at a time when the stock market has fallen sharply lower, therefore locking in a capital loss that would likely far exceed the income generated.
- If you subscribe to the minimum 5-year investment horizon, even though you can sell the ETF at any time, you have locked up your cash for a long period of time.
One other investment option for income hungry investors would be a Listed Investment Company (LIC) like WAM Capital (ASX: WAM). The LIC trades on a fully franked dividend yield of almost 7%. Dividends are paid twice per year.
Over the past 5 years, the investment portfolio performance of WAM Capital is almost 11% per annum. WAM Capital invests in a diversified portfolio of smaller companies than the Vanguard Australian Shares High Yield ETF, including Bega Cheese Ltd (ASX: BGA), Seven West Media Ltd (ASX: SWM) and Inghams Group Ltd (ASX: ING). The chief investment officer is industry veteran Geoff Wilson.
