An Investor’s Guide to Income Funds

By Rebecca Lake

Investing in the stock market involves two main objectives: growth and income. Growth investments can increase in value over time. Income investments can put money into your pocket consistently. An income fund is one way to cash in on the benefits of income investing in a simplified way.

An income fund is a mutual fund or exchange-traded fund that’s focused on investing in securities that are designed to generate income for investors. For example, that might be investing in dividend-paying stocks, bonds or Treasury bills, real estate investment trusts, money market instruments and shares of preferred stock.

The income these funds generate is current income, meaning you’re not waiting until some future date to receive a payout. That’s something that might be important if you’re looking for ways to create additional income streams in retirement or leading up to it.

Income funds work the same as any other mutual fund. However, their investments concentrate on income-generating securities. That means the share price of an income fund can fluctuate from one day to the next, the same as a traditional mutual fund or exchange-traded fund.

What distinguishes one type of income fund from another is what it invests in. So for example, you may be able to invest for income using bond funds, equity income funds, money market funds or hybrid funds.

Within each income fund category, there can be further divisions. Take bond funds, for instance. You might have a fund that derives income from:

• Treasury
• Municipal bonds
• Corporate bonds
• Junk bonds
• International bonds

A single bond fund could feature all five types of bonds or focus on just one. That’s one way an income fund can help you with diversification.

Likewise, equity income funds can also offer variety. An equity income fund is stock-focused and includes stocks that pay out dividend income to investors. A hybrid fund might combine multiple income investment types, such as a mix of stocks and bonds.

Money market income funds typically cater to more conservative income investments. For instance, you might invest in a money market fund that holds certificates of deposit or Treasury bills. The income these funds generate may not be as much as an equity income fund but they tend to carry less risk.

Aside from these options, you can also find income funds that focus on real estate. More specifically, real estate investment trusts or REITs. A REIT is a legal entity that owns real estate investments, such as hotels, retail space, commercial office buildings and multifamily homes. By law, REITs are required to pay out 90% of their dividends to investors as income. Investing in a REIT income fund is a way to reap the rewards of real estate ownership without the hassle of actually having to own property.

Other income fund options include ones that hold preferred stock or Master Limited Partnerships. Preferred stock shares pay out a fixed dividend to investors and take priority over common stock shares. A Master Limited Partnership or MLP is a partnership that can be publicly traded like a stock. An MLP can offer both income and tax advantages to investors.

Income funds can offer several advantages but they may not be a good fit for every investor. Here’s a rundown of the pros and cons at a glance.

• Simplified diversification. Investing in income funds can offer you broad or narrow exposure to specific asset classes. Since you’re buying multiple investments in a single fund, that could make diversifying your portfolio easier.
• Stable income payouts. A good income fund generates income for investors on a regular basis. That can make financial planning for someone who’s relying on that income simpler. For example, it may be easier to map out your monthly budget in retirement when you know which investments you can count on for income.
• May be cost-efficient. Mutual funds and ETFs have expense ratios, which determine your cost of owning the fund annually. Choosing income funds with low expense ratios means you get to hold on to more of your investment earnings.

• They aren’t risk-free. It’s a misconception to assume that income funds may be less risky than other types of mutual funds. If you’re investing in an equity income fund, for example, you’re automatically carrying a higher degree of risk than you might with a bond or money market fund.
• Income and performance are two different things. It’s also important to remember that the income a fund produces isn’t necessarily equivalent to its performance. A fund’s dividend yield, for example, may force you to overlook the bigger performance picture.

If you’re thinking that income funds might fit your investment strategy, it’s important to research them the way you would any other fund.

Specifically, consider:

• What the fund invests in
• The fund’s expense ratio
• How income pays out and how often
• Historical performance

With regard to funds that pay dividends, consider the dividend yield but also look at the fund’s underlying assets. A high dividend yield is great but not if it isn’t sustainable for the long-term.

When putting together a portfolio of income funds, remember to keep diversification in sight. If you’re investing in two equity income funds, for example, you’d want to make sure that each fund isn’t investing in the exact same companies. The same goes if you’re investing in two or more bond funds or real estate funds.

You can invest in income funds through a taxable account at an online brokerage and you may also have access to them through your 401(k) or IRA. Remember to evaluate the fees and tax efficiency of any income fund so you understand how much you’ll pay to own it.

Income funds can serve a distinct purpose inside a portfolio. As a result, there are several good reasons to include them as part of your retirement strategy. Take time to research different income funds. That can help you decide which of those funds may best meet your investment goals.

• Consider talking to your financial advisor about the pros and cons of using income funds for retirement. Even if you don’t have an advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to match with local advisors that will help you achieve your financial goals, start now.
• If you want to keep growth and income in sight, consider a growth and income fund. These mutual funds include investments designed to offer investors the best of both worlds. They can provide an investor with both capital appreciation and income.

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