These are crazy markets. The great global experiment of quantitative easing and secular stagnation in developed markets (weak demand and overcapacity) has distorted interest rates, and an ageing population has increased demand for higher-yielding securities.

That is not to say markets cannot rally. I believe markets are in the second stage of a bull market, characterised by slowly improving earnings. We are still a long way from the third stage of excess, where taxi drivers want share tips and friends quit their jobs to day-trade.

But it is getting tough for income investors to put new money to work and find sufficient, reliable yield to live on. They must accept lower income returns and higher risk as valuations rise and the capacity of large companies to lift or even maintain dividends is stretched.

How should self managed superannuation fund (SMSF) trustees, who prefer to invest directly and through listed rather unlisted products, respond? One strategy is looking further down the market for yield to small- and mid-cap industrial stocks. Or using listed managed funds, such as listed investment companies and exchange-traded products, to bolster diversification.

Many small- and mid-cap stocks seemingly offer attractive income. But their high dividends are sometimes an illusion, based on a falling share price that inflates the yield. The weak share price signals that the company has earnings problems and less capacity to maintain a dividend or even pay one. Rookie investors overlook the critical factor: dividend sustainability and growth in dividends per share.

Nevertheless, there are interesting yield opportunities in small- and mid-cap land for experienced investors who are willing to take slightly higher risks for higher returns. The key is minimising that risk through diversification or by buying quality, slightly undervalued stocks.

The ideas below show it is possible to achieve higher grossed-up yield than with the banks, Telstra and other prominent income stocks, through a listed-fund approach that lowers risks. Yes, the total shareholder return (including capital growth) might not be as good if CBA and Telstra continue their rally, but the ideas stack up for those mostly seeking income, without the risk of buying individual stocks at inflated valuations.

Here are three ideas to consider:

1. WAM Capital

Rising demand for yield and low-cost investment has underpinned a resurgence in the Listed Investment Company (LIC) sector in the past 18 months. Once described as the “dogs of the ASX”, LICs are growing rapidly as more fund managers launch LIC Initial Public Offerings, and established LICs raise capital and cater to yield-hungry SMSF trustees.

Wilson Asset Management’s WAM Capital is a good example. It lifted the fully franked interim dividend for the first half of 2014-15 by 7.7% to 7 cents. At $1.93, that equates to an annualised dividend yield of about 7%, or 10% after full franking.

WAM has consistently outperformed its benchmark S&P/ASX All Ordinaries Accumulation Index and grown dividends each year since the 2008 GFC. As a LIC, it manages a portfolio of stocks, giving investors high yield with better diversification than with owning a single stock.

WAM is trading at a 3% premium to its latest stated pre-tax Net Tangible Assets (NTA) of $1.88, after share-price falls in the last few weeks. It traded at a 16% premium to pre-tax NTA at the end of February, ASX data shows, and has consistently traded at a premium given the long-term outperformance of its underlying investment performance.

The premium compression after share price falls in recent weeks might be an opportunity to buy WAM Capital. It is still trading at more than its assets are worth, but investors have shown they will pay a higher premium for LICs that consistently deliver high, reliable dividend yield.

Chart 1: WAM Capital

Source: ASX, 19 March 2015

2. Russell High Dividend Australian Shares ETF

Exchange-traded products (ETP) that aim to replicate the price and yield of an underlying index have two key benefits for income investors. The first is diversification: the Russell yield ETP, for example, is based on an index that comprises 50 securities. The second benefit is low cost: the ETP’s annual management cost is 34 basis points, well below that of unlisted managed funds.

The Russell ETP has a 12-month trailing grossed-up yield of 6.49% (after 78% franking) – about 80 basis points better than the S&P/ASX 300’s average grossed-up yield. The index has been custom-designed to provide higher yield from large-cap companies.

Russell’s grossed-up yield is comparable with Commonwealth Bank’s, and the ETP has less risk because it is based on 50 stocks. Investors who view the big banks and Telstra like income-producing bonds, rather than higher-risk equities, could do worse than consider an ETP that provides a similar yield, without the single-stock risk.

Chart 2: Russell High Dividend Australian Shares ETF

Source: ASX, 19 March 2015

3. Contango MicroCap

Micro-cap stocks might seem an unusual source of dividend yield. Capital-hungry small companies typically reinvest more of their profits to aid faster growth, rather than give funds back to shareholders through dividends. And they are often too risky for income investors.

That is true of many micro-cap stocks. But higher-quality micro-caps, such as listed software service providers, often have capital-light business models and are able to pay higher dividends. Or they are well established and do not need significant capital investment to grow.

Another LIC, Contango Microcap, specialises in small- and micro-cap stocks. It had an 8.2% trailing dividend yield at February 28, 2015, ASX data shows.
Contango declared a 4% interim dividend for the first half of 2014-15 — 50% franked (up from 25% franking in 2013). At $1.05, its annualised net yield is 7.6%, or 9.2% after partial franking.

As with other LICs, Contango offers exposure to a basket of micro-cap stocks, thus improving portfolio diversification. Moreover, it’s worth paying fees for professional management in the sometimes treacherous world of micro-cap investing.

Contango traded at a 7.1% discount to pre-tax NTA in February 2015, ASX data shows, meaning its assets can, theoretically, be bought for less than they are worth. Contango arguably should have some discount factored in, given the lower liquidity of its underlying micro-cap portfolio. But it is still cheaper than many other LICs that trade at a premium to NTA.

As the Australian economy improves in 2016, and as a rising equity market attracts more investors, small- and micro-cap industrial companies should collectively perform better, meaning Contango could narrow the gap to NTA in the next year or two.

Chart 3: Contango MicroCap

Source: ASX, 19 March 2015

– Tony Featherstone is a former managing editor of BRW and Shares magazines.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.