Investment Insider: How to build your own income fund

You do not need a professional to create a cash-generating portfolio if you follow a few basic rules

It would seem that investors are moving away from growth funds and into income-generating funds. According to the research group Lipper, income-focused funds in the US, which tend to invest in companies with high dividends, saw inflows of $31bn last year.

By comparison, capital-focused funds saw outflows of some $84bn.

The numbers themselves are insignificant when compared with the gargantuan US mutual fund market, which is worth more than $11 trillion. The movement of money represents only around 0.5 per cent of the total funds under management. But the sentiment of shifting from growth to income is something that chimes with emails I receive from investors.

The thing is, although the UK stock market was largely unchanged in 2011, the volatility that investors had to tolerate over the year tells a different story. Last summer, the FTSE plunged almost 1,000 points in just few weeks before staging a slow recovery. The stomach-churning drop is something many private investors found uncomfortable.

Income investors, on the other hand, take a different approach to volatility. They are aware of fluctuating share prices but comfortable that dividends are paid whatever the prevailing share price. If, for example, you own 100 shares in Vodafone, that are supposed to pay 6p dividend for every share you hold in June, you will get a £60 cheque regardless.

A hankering for income is nothing new and certainly not something that came about solely as a result of the recent market volatility. Neil Woodford, who runs the Invesco Perpetual Income fund, has been an income generator for more than two decades. However, you don't need to pay a professional to manage your income fund. It can be just as easy to construct your own by following a few basic rules.

The first is to have a diversified portfolio of shares selected from different industry types. So if you like the look of British American Tobacco, then it is best not to also have Imperial Tobacco. If history has taught us anything, it is that putting all your eggs into one sector may be risky. Just think back to what happened to bank shares in 2007.

It is also important not to just look at the dividend yield in isolation. It can be a mistake to cherry-pick the highest-yielding shares, especially those that yield significantly more than the market average. Don't be too greedy. Instead, look for companies that may not necessarily have super-high yields but have reliable yields that don't depend on strong economic growth. An example is the pharmaceutical sector, which tends to see sales grow as the population expands.

Take a look also at what proportion of profit is being paid in dividends. After all, you want to see a business retain some profits for expansion. You also don't want to see a company borrowing to pay dividends. In the main, profits should be around 1.5 to two times higher than the dividends paid.

Don't dismiss companies that may have a low dividend yield especially if the payout is growing quickly. A 3 per cent yield can become a 7 per cent yield in five years if the payout grows at 20 per cent a year. There is an additional bonus in store because the share price may grow in tandem with the dividend payouts. For the income investor it can be quite a coup to get a higher payout and a higher share price a few years later.

Below is an example of an income portfolio drawn solely from the FTSE 100. There are a couple of things to note about it: each holding is less than a fifth of the size of both the overall portfolio size and the total dividend payout. Consequently, as share prices move and dividend forecasts change, the proportions could also change. But more importantly, you are not relying on a handful of shares for your income.

David Kuo is director of fool.co.uk