What are Income Funds?
Income funds are mutual funds, ETFs or any other type of fund that seek to generate an income stream for shareholders by investing in securities that offer dividends or interest payments. The funds can hold bonds, preferred stock, common stock or even real estate investment trusts (REITs).
How Do Income Funds Work?
Income funds can be conservative to risky investments, depending on the holdings. Some funds only invest in securities from established, creditworthy companies that make consistent dividend or interest payments, making them relatively conservative investments. Other funds invest in riskier investments like REITs and junk bonds and for higher yields than other, more conservative funds.
As with other funds, one of the greatest advantages of income funds is instant diversification. However, the inclusion of both stocks and bonds in the same fund takes some income funds to another level of diversification. Stock and bond prices generally have a negative correlation -- when stock prices go up, bond prices tend to go down and vice versa. Because some income funds invest in both the stock and bond markets, income funds usually offer an added hedge against market risk. However, some analysts argue that as interest rates and inflation fall, the negative correlation is not as strong, and the hedge is not as effective.
It is important to note that the goal of maximizing income doesn't always result in regular payments to income fund investors. Many income funds (especially "growth and income funds") do not make regular distributions, instead they make special payments when they see fit. Investors should read the fund's prospectus and do other research before investing.
Why Do Income Funds Matter?
Income funds make it easy for investors to invest in a diversified pool of dividend or interest paying securities. It's important to note that the price of the funds are not fixed and fluctuate with market conditions. However, capital appreciation is secondary to high current income and capital preservation.
Income investors must consider their risk tolerance, the fund's expense level and the fund's tax efficiency for their particular circumstances. The prospectus is the most important document to study because it details not only the fund's fee schedule but also its investment methods, goals and strategies, and the fund manager's background. For investors with longer-term investment horizons, income funds can boost income and help diversify a portfolio.