If I put £20,000 into the FTSE 100 index ETF, here is the secondary income I will get.
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Passive index investing has grown in popularity in recent years and I can see the appeal. It's less expensive, less hassle and can produce a decent second income if the index pays a good yield.
I FTSE 100's known for its high benefits. So how much can I expect to get back each year if I put the entire £20k Annual Dividends and Shares ISA into a tracker fund? Let's take a look.
This FTSE 100 Limited company paid a dividend of 3.56 %. This is based on current share prices and the total number of dividends declared by voters over the past 12 months.
However, this does not include special benefits. This is when a company has excess cash (from say the sale of assets or a special dividend) it wants to distribute to shareholders. They are usually one-time payments. For example, I received a special dividend HSBC in June following the dissolution of its Canadian business.
Adding those in the bulls the yield of the FTSE 100 comes to 3.75%. So when I invest in an exchange-traded fund (ETF) that tracks the Footsie, I should expect a slightly lower return after accounting for the ETF's management fees.
This assumes that the yield remains constant, which is not guaranteed as dividends can be reduced and share prices fluctuate.
Putting this together, it means I can expect around £730 a year on a £20k income.
Levels are falling
Is that good? Not especially when interest rates are still so high. Investors who currently hold cash can get better returns without the risk of losing the FTSE 100 to a big drop.
On the other hand, the FTSE 100 could rise. It's up 7.5% on a per-share basis so far this year.
Interest rates on savings accounts are expected to drop significantly in anticipation of deflation. My savings account with digital bank Tandem was paying me 5% interest. It is now 4.4% and will probably go down.
As and when the Bank of England cuts rates, FTSE 100 yields should start to look more attractive.
A better strategy
However, some individual stocks already do. In fact, it's a few mouth-watering looks.
| Dividend Yield | |
|---|---|
| Phoenix Group | 9.45% |
| IM&G | 9.28% |
| Legal & General | 9.18% |
| British American cigars (LSE:BATS) | 8.51% |
| HSBC | 7.12% |
I already own three of these (Legal & General, British American Tobacco and HSBC). If I were to invest my £20k equally between these, the yield would be an average of 8.27%. That means I can expect a second annual fee of £1,654, rather than £730. More than double!
Of course, this involves taking more risk on individual stocks like British American Tobacco. The company is dealing with a long-term decline in smoking rates around the world. And while its smokeless division, which sells vapes and pouches, is growing, it's far from certain that these will ever offset falling cigarette prices.
For me though, these risks outweigh the stock price. It trades with rock-bottom forecast earnings of 7.3. That's surprisingly low for a company that generates significant dividends. After all, it is unlikely that smoking and vaping will disappear overnight.
Over the next five years, the tobacco giant estimates it will generate around £40bn in free cash flow. That should be enough to cover the huge dividends it pays out to shareholders.
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