What is passive income, anyway? And why do I love it so much?

A Russian proverb states, “Those who take no risks, drinks no Champagne”. So that’s why I use these simple investments to generate powerful passive income!

Posted by Cliff D’Arcy

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

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When I first started investing in the late 1980s, I was studying maths, statistics, and computer science. This gave me a leg-up in understanding financial markets, so I’ve been trying to build wealth ever since. However, I often hear students and young people say they ‘hate maths’ and don’t understand investing. So here’s my quick guide to one of my favourite things: passive income.

What is passive income?

Passive income is earnings that come other than from paid work. Nevertheless, some passive income requires hard work, such as managing rented properties — dealing with tenants and their problems. I’m too lazy for this, so I haven’t built a property empire.

Unearned income can come with little effort, such as savings interest from cash deposits. That said, I don’t know many people who got rich from avoiding all risks, so I don’t keep tons of cash in savings accounts.

Owning bonds is riskier than saving in cash, because these fixed-income securities are IOUs (debts) issued by companies and governments. If trouble arrives, their coupons (interest) and capital (the initial investment) could be under threat. Even so, my wife and I own a wide range of bonds through a single money-market fund.

My favourite unearned income

However, my preferred form of passive income by far is share dividends. Some people believe that owning shares is no better than buying lottery tickets. However, my goal is to become part-owner of a wide range of great businesses. And when these companies do well, many of them choose to pay out dividends to shareholders.

Most members of the UK’s FTSE 100 index pay dividends. This makes the Footsie my happy hunting ground for generating passive income. Still, future payouts are not guaranteed, so they can be cut or cancelled at short notice (as happened in Covid-hit 2020/21). But as American tycoon John D Rockefeller once remarked, it gives me great pleasure to see my dividends coming in.

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Story by Royston Wild 2024

Dividend shares are (in my opinion) one of the best ways to target a long-term passive income. With the use of a Stocks and Shares ISA, investors can build a large and steady income stream with shares, trusts and exchange-traded funds (ETFs).

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

Choosing funds

It’s critical to remember that dividends are never guaranteed, as company payouts during the pandemic showed. As the Covid-19 crisis exploded, even the most reliable of passive income stocks cut, postponed or cancelled dividends entirely as earnings faltered and balance sheets deteriorated.

Yet over the long term, we’ve seen that a well-diversified portfolio can deliver a reliable stream of dividends. A portfolio whose holdings are spread across dozens of companies, industries and regions can provide a solid income across all points of the economic cycle.

Here are two top ETFs worth considering that I believe could deliver a large long-term dividend income.

1. Broad appeal

With holdings in scores of companies worldwide, the SPDR S&P Global Dividend Aristocrats UCITS ETF (LSE:GBDV) offers excellent diversification straight off the bat.

In total, this ETF has holdings in just over 100 different shares. Major holdings range from Verizon Communications and CVS Health to Universal Corp.

On the downside, half the fund (49.5%) is tied up in US shares. This means it carries greater geographical risk than more regionally spread vehicles. However, this allocation also taps into the long-term outperformance that Wall Street has enjoyed.

This SPDR ETF’s quest for dividend growth doesn’t mean that yields are sacrificed however. Its 12-month trailing dividend yield’s currently a market-beating 3.9%. During the last five years, the fund’s delivered a total average annual return of 10.5%.

2. A targeted approach

Investing in property stocks is another way to target a dependable passive income. There are many themed ETFs available to play this hand, one of which is the iShares MSCI Target UK Real Estate (LSE:UKRE).

Thanks to their consistent rental incomes, property stocks tend to enjoy consistent cash flows that support regular dividend payments. I like this particular fund because it focuses more specifically on real estate investment trusts (REITs). These investment vehicles are required to pay at least 90% of annual earnings from their rental operations out in dividends.

What’s more, the REITs it holds span multiple sectors including healthcare, retail and residential, providing an attractive balance of reward and safety. A large portion of the fund’s also dedicated to UK government bonds as well, which provides added security.

Since 2020, this iShares fund has delivered an average annual return of just 0.6%. It could continue disappointing if interest rates remain higher than normal. But with inflation dropping, I expect returns to improve strongly from this point.

The 12-month trailing dividend yield here’s a huge 6.6%.

It’s critical to remember that dividends are never guaranteed, as company payouts during the pandemic showed.

The Snowball invests mainly in Investment Trusts as most have reserves to pay their dividends in time of market stress.