while many investors focus on capital gain, where you buy low and sell high, for some investors, the focus is on income. So, in this video, we look at the reasons for that, both good and bad, and I'll show you where we can find the best income from index funds right now. This video is sponsored by Trading 212, a UK zero-commission investment platform. Let's begin with why you choose income-paying funds. Now, if you're in the accumulation phase of your investment journey, you're still saving for a future retirement or perhaps a big expenditure, then an accumulation fund usually makes more sense. These are funds that don't pay out an income into your brokerage account; instead, they reinvest any income generated by their investments back into the fund. They do that more cheaply and more efficiently than we could do it ourselves. However, if you're in retirement, then you need an income, so an income fund makes more sense. So, the way these work is that they pay out regular payments into your brokerage account, which you can then withdraw into your

bank account. You don't have to actually sell anything in order to get that cash out of your investments. Whereas if you have an accumulation fund, then the money's automatically reinvested back into the fund. Now, you could still, of course, withdraw money from that accumulation fund simply by selling some of the fund. Now, there isn't a huge penalty that goes with that unless you're holding the fund outside a tax-sheltered account. In the UK, that would be an Isa or a sip. In the US, a Roth IRA or perhaps a 401k account. And that's because if you sell something and its price has gone up since you bought it, you'll be liable for capital gains tax. So, there is a tax justification for holding income funds. I think another justification is a psychological one. People just find it reassuring that you don't have to sell anything. You're not killing the goose that lays the golden eggs, and yet it's still paying you out an income. You're still benefiting from that investment. I think that's actually

a bad reason to have an income fund because what really matters is Total return in the UK. For example, there are many funds which have paid out a high dividend, but they've sacrificed capital gain in order to generate that. Consequently, your income would have fallen in real terms. But for the funds we'll be talking about today, we'll be focusing on the income that generates. So, I'm assuming here that you're someone who's in retirement and needs the income. Now, different funds will have different prices, so what really matters is what proportion of the income is generated for a given capital investment. The way we measure that is with something called dividend yield. The way that's usually measured is to look at how much income your investments generated over the past 12 months and then divide that by the price of the fund today. Another way to think of that is you divide what you want income by what you have to pay for it, the price today. Now, that is quite volatile because of the denominator. The price will be varying day-to-day. The

income doesn't usually vary as much, but if we are comparing different investments, this is what we compare: dividend yield expressed as a percentage, and that's what we'll be using throughout this video. Now, for people who've got our premium membership on pensioncraft.com, we offer this tracker, which allows you to drill down into various funds to see which ones offer the best dividend yield. Here, it's broken down by sector, so these are various ETFs in the UK, and you can see the size of each fund according to the area of its block. The shading tells you what dividend yield that fund generates, so red is relatively low income and green is relatively high. So, this is what the tool looks like on our website, and you can drill into any of these categories. So, for example, if we choose US ETFs, you can see that a lot of the income comes from the high-yield category. So, if we drill into high-yield bonds, notice there's a sea of green here. This Invesco C loone ETF, for example,

generates a yield of 8.8%. This high yield Bond ETF spy generates 7.8% and so on. It's also the case that for the UK, high yield bonds are a reliable source of high income, although we'll see more about that in a moment. So, what we're going to do now is to go through various categories of income-generating funds. Each one has its own risks that go with that income, and it's always good to balance the return you get with the risk you have to take to generate the return. And we'll begin with high dividend yield stock funds. Now, the UK, as I mentioned earlier, is usually a fairly high generator of dividends. Historically, it's been a generous dividend payer, but at the moment, if you look at the footy 100, for example, the dividend yield is below 4%. So, not so generous relative to other sources of income. If we break down some of the Sterling denominated funds, which you can see here beside me, notice that often you

have to choose a sector. You have to concentrate in that sector to generate a high income. The highest yield on this table, for example, is this Invesco Morning Star US Energy infrastructure MLP fund. MLP stands for master limited partnership. Am I focusing on infrastructure for US energy? That's a sector that tends to pay a high income. However, it also introduces concentration risk. What if there's a pullback in energy prices, for example? That would negatively impact your fund, and it's often the case if you drill below the surface that one of these income-generating funds, such as the second one on the list, this Global Select dividend 100 swap fund, will often have some kind of concentration risk within a sector or a country. So, it's always worth digging into the funds to work out what those risks are and to make sure that you're happy with them. Notice also, and this is a theme that'll go throughout this video, that the fees on these funds are relatively high. You can buy a global index tracker for less than

0.15% annual fees, whereas a lot of these funds come at more than 5% per year. Other regions that tend to generate high dividends would be Brazil, for example, that has a lot of financials and energy companies. Also, emerging markets generally and also Asia Pacific, which if you look for developed markets, is dominated by Australia. And that's because Australia also has a lot of commodity companies and a lot of financials, which are high dividend payers. The UK dividend plus fund, I UKDS, also there, that's got a yield of 5.5%. Or you could go for something like a preferred shares fund, which buys a specific part of the capital structure that tends to pay out high dividends. Again, that's usually focused in one sector, which is financials. Today's video is sponsored by Trading 212, a UK zero-commission investment platform that I've been using for some time for my fund portfolio. And one of the features I've been using a lot is the PI feature. So, if you've got

an investment strategy, and I like to run lots side by side. Then, it's a nice way of keeping them separate from one another within your portfolio. And if I want to rebalance one of the strategies, all I have to do is click a button. Also, another great feature of pies is you can set up autoinvest, which is a great habit to get into for regular automated saving. There's also a social aspect to pies, where you can publish your Pi for other people to see, or you can look at other people's published pies for inspiration for yours. If you trade US stocks, then 245 Trading gives you non-stop market access from Monday until Friday via more trading sessions while still using Trading 212's fractional shares, and also it's zero-commission trading. You can also switch between 245 and regular hours orders at any time. Now, as a viewer of Pension Craft, you get a special offer from Trading 212, where you can claim free fractional shares worth up to £100. In order to claim that, open and verify your Trading 212 account, fund it with at

least a pound, and then use the promo code within 10 days of opening the account, which is my name, Romen Ra. Alternatively, you can use the link in the description below. Real estate and infrastructure funds are also a reliable source of high income. Now, there are two classes of funds which give you exposure to these asset classes. Personally, I'd go for the ones in the bottom panel. These are investment trusts. The reason for that is that they are closed-ended funds. They have fixed pools of capital, and that means that if they become popular, money doesn't flood into the fund; that just can't happen. And if they become unpopular, money doesn't flood out. That means they're never forced buyers or sellers of assets, which is just as well because real estate is very difficult to sell. It's very illiquid. So, having a liquid wrapper around an illiquid asset is usually a recipe for disaster. So, while you can buy Real Estate Investment Trusts, which have an open-ended wrapper, that's the top panel that you can see here, I'd usually go for

the investment trusts, despite their higher fees. So, here you can see a variety of real estate funds. For example, the one at the top of the list, the Super Market income rate, is generating a yield of 7% as I make this video. If you want infrastructure, for example, for wind power generation, then Green Coat UK Wind is currently offering 6.4%. Now, what are the risks that go with these funds? Well, usually they have some kind of cyclical exposure to one country. If it's energy generation, for example, you'll find a lot of those funds are based just in the UK, or the infrastructure is just UK-based. So, you do have that concentrated geographic exposure, also concentrated sectoral exposure. So, just make sure that you understand the portfolio of assets which is owned by each of those trusts or funds and that you're happy with it. Our next category is high-yield corporate bonds. High yield simply means that these are poor quality credits. They have slightly dodgy default risk. Now, because bonds come with a credit rating between

AAA at the top, all the way down to single C at the bottom. The cut-off between investment grade, that's the good stuff, and the junk bonds at the bottom, or high yield, or speculative credits at the bottom, happens as we go from Triple B to Double B. So, go from investment grade to high yield. Now, because you're taking a greater default risk with high yield bonds, you're paid a higher income. So, if we break down the total yield for investment grade bonds and for speculative or high yield bonds, they do have one factor in common, which is the risk-free rate. That will be the same for both sets of bonds, assuming they have the same maturity. Layered on top of that will be an additional income, which is based on the credit risk you're taking. That's called the credit spread. Now, the credit spread on high yield will be bigger than the credit spread for investment grade because the default risk is higher. So, you should be compensated for it. In addition to that, the liquidity of high yield bonds is worse than for investment grade. If

there's a ShakeOut in the market. Usually, those bonds are very difficult to sell, so you are paid a premium for that IL liquidity. So, that's why the all-in yield for high yield is great G than it is for investment grade. However, that credit spread that you're paid for taking the additional credit risk varies over time. And if we look at high yield in the US and in Europe right now, you can see that the credit spread is very tight indeed. You're really not being paid much additional yield to take that credit risk. However, what has happened is that the risk-free rate has increased all across the world. So, the all-in yield for high yield is currently pretty good, but it's not because of the additional credit spread. So, if we look at the performance of three funds, one of them is an investment-grade fund, that's LQD. We've also got a junk bond fund in the US, that's HYG. And we've got a US Treasury fund. Notice how all of them fell together as risk-free rates.

increased, and that's because as the yields increased on all three categories of bond, the prices fell. So, the fall in junk bonds wasn't because the credit spread was widening; in fact, the opposite was happening. There was a spread compression. The fall, which is roughly the same for all three funds, notice, was because the risk-free rates were increasing. So, at the moment, I just don't think these are very attractive, simply because you don't have that icing on the cake, the credit spread, and I'd wait until there's a bit of a ShakeOut in the credit Market until I buy this asset class. However, the yields you receive for them are actually quite respectable. Many of these funds have a yield which is currently in excess of 7%. But, as I say, a large proportion of that is due to the risk-free rate, not the credit spread. But this is definitely one to keep on your radar for when there is a ShakeOut in the high yield Market, when credit spreads will widen, and then you'll get the whole kitten Kaboodle, a big

risk-free rate combined with a wider credit spread. Another risky class of bonds is Emerging Market Sovereign bonds, and these come in two flavors: hard currency and local currency. So, let's say you're the Mexican government and you need money. You can either issue bonds issued in US dollars, so that makes it more palatable to US investors; they're not taking a currency risk directly. Or you could issue it in your local currency, the Mexican peso. Now, as an investor, you probably take less currency risk buying hard currency EM bonds. If you do get exposure to EM local currency, that tends to make the fund more volatile once you overlay that currency volatility. Now, the risk here is partially illiquidity. Another risk, I think, is very much to do with the EM itself. Emerging Markets are simply more accident-prone, whether it's a political accident or a currency crisis. So, it's always worthwhile looking at the breakdown, the geographic breakdown of the fund you own. For example, if we look at this iShares hard currency EM fund, notice that it has a lot of energy.

producing producing countries in its highest exposures Saudi Arabia, Mexico, and so on. So indirectly, you also have exposure to commodity prices, in particular oil. Here, and if we look at a local currency EM Sovereign bond fund, also from I shares here, notice how China's second on the list for exposure. Now, some people aren't comfortable with China exposure at the moment because of the geopolitical strains with the US. So, that's certainly something to bear in mind. And the yields here aren't particularly high, many of them are above 5%, some above 6%, but that does come with its own risks. The final category we'll look at is covered call funds. I think the best way to explain how these work is to dig into one example, and this is a Global X fund called QLD. Now, what this fund generates is a dividend of about 12%, which is very high indeed. How does it do that? Well, it's not risk-free. Every month, it sells an at-the-money call option, which sells the upside on the NASDAQ 100. Once that option expires

it sells another one, and another one, and it does that every month. The premium or the income generated by selling that option enhances the income of the fund. So, if we compare this covered call fund with a Tracker of just the NASDAQ 100, like QQQ, or a UK equivalent like EQQQ, the payoff for the covered call fund is shown in yellow, unlike the straight Index Fund, which is the red line, which just moves up and down one for one with the underlying index, the NASDAQ. Notice how there's a kind of hockey stick shape for the covered call fund, and this is why it's not a free lunch, because what we've done by selling the upside to somebody else is that we've stopped participating in that upside. So, if the NASDAQ roars upwards, we're not going to have any exposure to that upside. We've kept all of the downside, but the reason why we're willing to accept that fairly toxic combination of all the downside with the upside is that we've pushed the whole

graph upwards, and that's because of the income which was generated by selling the option. Now, the income that the option selling generates is greater the more volatile the index. So, the NASDAQ generates a higher income than, say, the S&P 500. And in fact, for UK investors, Global X does have two funds which are available that give you exposure and covered call form to the S&P 500 and the NASDAQ. Now, the ticket for those two funds which end in P tell you it's denominated in pounds in Sterling. And we can do a quick back of the envelope calculation for the dividend yield from those two funds. So, I did that for the dividend that's going to be paid in August. The X dividend date for that was in July, so we know what the dividend will be. And what we're going to do is annualize it, so just multiply it by 12, assuming that the dividend will be roughly constant. So, for example, the NASDAQ covered call ETF is going to pay a dividend of 17. And if we divide that

by the price of the fund, which is $16, the yield, if we annualize it, is about 12%. Very high indeed. Compare that with the S&P 500 covered call fund, and there the dividend yield is only 8%. Still pretty good, but not as good as the NASDAQ because it's less volatile. Now for these covered call funds, remember you should never buy anything you don't understand. So if you're not comfortable with a derivative, don't buy it. And that brings us on to the problems with these income funds. If we look at the US market and break it down by sector, you can see that in order to generate a high dividend yield, there are only certain sectors which are generous. So that's energy, real estate, utilities, and the sectors which have done incredibly well over the last decade like Tech and Communication Services pay the most stingy dividend because they're growth stocks. So by having a tilt towards income, remember that you will also be tilting towards sectors and countries. So just make absolutely sure you're happy.

with that tilt, look at the contents of the fund and just consider whether you're happy with that. And finally, I think if you look at money market funds at the moment, even after the First Rate cut from the Bank of England, you're still seeing rates of return which are above 5%. And remember, you're taking very little risk for generating that return. And that means that the bar for income is now set very high. As inflation continues to fall around the world and central banks cut rates, then that barrier will be lowered, and these dividend income funds will become more attractive, and more of them will become worthwhile. But certainly at the moment, just remember that you can generate a very good return for taking a very small risk. Hopefully, that's giving you an overview of where we stand at the moment with income globally and how you can generate it. But always be careful that you're happy with the risks you're taking to generate that return. Drill into the contents of the fund and understand what's there. Now, don't forget

Our offer from Trading 212. Viewers of Pension Craft can claim free fractional shares worth up to £100. Just create and verify a Trading 212 account, fund it with at least a pound, and then use the promo code, which is my name, Romen R M I N. Do that within 10 days of signing up, and you can also use the link in the description below. And as always, thank you for listening.

Best Index Funds for High Dividend Yield

My name is Ramin Nakisa and I started PensionCraft in 2016 as I felt strongly that I wanted to teach people how to invest well for themselves so they could stop making costly mistakes and losing their money through having to pay unnecessarily high fees.

Before starting PensionCraft, I worked in investment banking as a strategist and I was a frequent contributor on CNBC and Bloomberg TV. I have written two books about finance and investment: one for professional investors and one that explains how to buy and sell volatility using exchange-traded products.

I publish a new video on YouTube every Saturday and you can join me for a live Q&A on the 1st Thursday of every month at 7pm UK time.

If you want to learn how to become a better investor then why not join our friendly membership at pensioncraft.com?
