All things being equal, having more income is preferable to having less.
But all things are not equal. Income-focused funds cover all asset classes and risk profiles and are a compromise between risk, yield, predictability and sustainability as well as capital preservation.
Reaching for higher income may involve a correspondingly bigger step up in risk, while pursuing investments in low-risk assets will come at the cost of a lower yield. Meanwhile, an investment in negatively yielding securities, of which there are $12.5 trillion1 worth, may guarantee real losses in return for a promise of liquidity.
Equity, fixed income and multi asset funds all take slightly different routes to income, reflecting the various priorities investors may have depending on their needs. These factors include market conditions and personal preference.
With that in mind, it is worth looking under the hood of the three different asset classes to understand that similar headline yields may be arrived at in a multitude of ways, expressing different market philosophies.
An equity income strategy offers relatively low-volatility returns, compared to other equity investing approaches, and a greater emphasis on capital preservation.
This typically means scouting for companies with discipline on costs, sustainable profit outlooks and low levels of debt. Equity income fund managers often look for securities in industries with high profit margins, high barriers to entry and a long track record of paying dividends. The sustainability of profit, rather than its growth, becomes the focus. A stable business is unlikely to cut dividends.
These signals are important. In 1988, Eugene Fama and Kenneth French2 found that “earnings are more variable than dividends,” and that the power of dividend yields as a predictor of future return increases with the length of the investment horizon.
More recently, dividend strategies have drawn increasing interest from investors around the world. For a start, dividend yields have generally increased over the past 20 years from 2 per cent to an average of over 4 per cent in the UK in an environment of falling bond yields.3 As a result, an overall strategy of focusing on stocks with high dividend yields, and on those with a history of growing their dividends, has produced higher returns, with less volatility, than the global equity market as a whole.
And the longer the investment horizon, the greater the reward. If a forgetful relative had invested in the US stock market in 1900, the vast majority of the total return would be from reinvesting dividends, rather than capital growth. $100 invested in 1900 would give a real total return of $139,400 by 2015, with dividends compounded at an average of 6.5 per cent. By contrast, the price return without dividends would be just $1,000.4
But while equity income returns may be historically less volatile than other strategies, it is wise to tread carefully. Vodafone had what used to be considered one of the safest dividends in the market until it was slashed by 40 per cent in March 2019.5 Similarly, the 2008 banking crisis saw entire swathes of the financial industry slash, suspend and end dividend pay-outs.
As such, equity income is a strategy suitable for clients who want some capital growth over time, alongside the income, and are happy to take the risks that go along with it. With its focus on solid companies with sustainable profits, it is often considered a less volatile and more defensive style of investing than, for example, growth. But it can also promise large rewards over the long term for those with an appetite for risk.
The secret to the market
Michael Clark, Portfolio Manager, Equities
“Everybody goes on a journey. I used to be very focused on value investing as set out by Benjamin Graham. That seemed to me to make a lot of sense. And at some points in the market, it works really well. Perhaps the best example of this is the Asian crisis in the 1990s. To buy stocks focused on Asia, in the pit of the bear market, in the late 90s, was an absolute winner, because Asia recovered dramatically from that crisis.
"It has worked less well in the past decade. I think one of the reasons why is that a lot of traditional companies have become over-indebted, and they don't revert to the mean as a result. And there are some big shifts going on in the way business is done, for example in retail. It’s moving online and pushing retail stocks low. Again, the reversion to the mean doesn’t quite work in a new environment like that.
"I think it's important to have a philosophy about how to approach investments in the market, but it has to be able to evolve. You can't stay rigid. Market conditions change, industries change. So, while I used to be very focused on value investing, I began to look again at the guts of the stock market. It seemed to me that when you see the real mechanics of how the market works over the longer term, the lion’s share of return is the dividend compounded, and the capital gain is actually relatively small in comparison, if you draw it out over decades.
"The secret to the market, if there is one, appeared to me to accentuate and magnify that compounding effect of the dividend. So, if you have a higher yield on your funds than the market’s average, then you should do better over time. It does work, but not in a linear fashion every year. You can have two or three years in a row where it doesn't work. But if you stick to it, it works. And so I was very pleased to take on the equity income funds here in 2008. The thing about the market is that it changes all the time. And that was a good time to change with it.”
Fixed income is usually considered to be at the more conservative end of the spectrum in terms of risk profile for investors, focusing on predictable returns with low capital risk.
But there is no easy solution to the problem of generating income in a low interest rate environment, particularly for investors based in the Eurozone. Including the huge and growing pile of negative-yielding debt, the average yield of the global bond market is now just 1.76 per cent, down from 2.51 per cent in November last year.6
The mix of credit quality that investors have to accept to generate a reasonable income stream introduces the potential for downside risk and losses. As a result, yield generating assets will often come in the form of US dollar denominated emerging market corporate debt, or high yield corporate debt issued by companies rated between BB and BBB.
Source: Fidelity International, 2017.
Funds can come in different shapes and sizes. Some may invest solely in government bonds, prioritizing capital preservation over income. Others may offer a mix of different securities, combining high yield bonds, cash and investment grade credit to produce a steady yield over time.
The high yield component of a bond portfolio can act like an accelerator pedal. Increasing exposure to the asset class may help a portfolio reach its target yield, but also increases the risk of losses down the line.
A typical global fixed income fund may cap high yield exposure at 50 per cent of assets, retaining the potential to add risk if market conditions favour it. Such a fund would typically aim for around 4 to 5 per cent yield, building risk onto a base of dollar denominated cash instruments and US treasuries, and providing a stable stream of income for an investor with a preference for certainty over risk.
Past and future
Peter Khan, Portfolio Manager, Fixed Income
“I grew up in the in the Bay Area and went to university there, close to the start of the first bubble in Silicon Valley, as it took off. And there were a lot of interesting and sexy things about that time from an intellectual and technical point of view.
"But I think the thing that attracted me most to fixed income relative to equities, is that there are so many different variables that can influence your outcome, depending upon the asset class that you choose.
"I do think that, as credit investors, we historically tend to look in the rear-view mirror. I don't think that that style of investing really suits the credit world, with its modern income seeking, all too well. You clearly need to know your history, but you also need to take a page out of equity’s book and project into the future in a systematic and informed way. The combination of the two things is what appealed to me.”
Fixed income and equity funds may feature a range of different securities but multi asset income offers flexibility across all asset classes.
They can change their allocations to equities, bonds and alternative investments depending on the economic environment and where investors see the greatest opportunities. In this way, they can flex with the market cycle, taking on more risk when opportunities dictate, while increasing the allocation to defensive assets, such as bonds, in other times.
Our multi asset income funds aim to deliver capital preservation, low volatility and an income of between 4 per cent and 6 per cent. Those three objectives are achieved by blending together different asset classes, taking advantage of the wide variety of opportunities on offer.
This mix would usually include government bonds, investment grade corporate bonds and cash to preserve capital, high yield bonds, emerging market debt and other income producing assets such as loans. Finally, growth assets such as equities, infrastructure and real estate investment trusts complete the mix.
Multi asset funds also have the ability to invest in alternative investments, which provide a source of income that is uncorrelated with the wider market performance of bonds and equities. These alternative assets can be in the form of real estate, infrastructure, asset leasing or investments in renewable energy projects, to name a few.
This freedom allows the fund to invest through the corporate capital structure, from equity to different debt products, picking up opportunities in whatever form they come.
A multi asset strategy is also able to take advantage of market premia as they present themselves. This could be in the form of an illiquidity premium, a complexity premium, or even an attractive pricing or contractual arrangement because of the difficulty of access to the asset in general.
What the bank can’t give you
Christ Forgan, Portfolio Manager, Multi Asset
“Income investing is seen as a more defensive, more cautious style. For example, the equity income investing approach traditionally gives you exposure to the more defensive sectors, and, therefore, typically performs better in risk-off environments.
"This chimes with what I believe is my inherent natural conservative nature. For me, it's about whether we can mitigate a lot of the downside during the risk-off periods, whilst participating on the upside and therefore deliver an attractive return profile for clients over the medium- to long-term. It’s an approach that focuses on the overall outcome for clients and why I’m drawn to it as a style.
"I’m also attracted by the challenge of providing an income in today's markets, because traditional sources of income continue to face challenges. The bank, for instance, can’t give you that. Therefore, what we're looking to provide is an alternative source of income, in a manner that investors can have confidence in, namely capital preservation and low volatility. And if we can deliver on those characteristics whilst maintaining the level of income, I think it's a very attractive proposition for the end investors in a market environment that has been starved of yield for the best part of 10 years.”
Three income portfolio managers walk into a bar. One orders a beer, the other a white wine and the last one a whisky. While their objective may be the same, a steady flow of conversation, the routes they take to get there are subtly different.
So it is with income investment strategies. Each asset class has its own method of generating a steady and predictable flow of cash to the end investor, with unique risks and opportunities for different investor needs.
For equities, it may be mixing capital growth with low volatility returns, for fixed income, it is a focus on capital preservation and reliability of incomes, and, for multi asset portfolios, flexibility in uncertain market environments and the chance to find value at different points in the corporate capital structure.
In general, income pairs well with the late cycle market environment, because the funds are often focused on high quality bonds, defensive stocks and uncorrelated alternative assets. This approach can be a counterbalance in times of sudden volatility spikes. But, while it can help investors navigate uncertain markets, there are no risk-free lunches.
1: Wigglesworth, R. (June 2019): Value of negative yielding debt hits record $12.5tn Financial Times
2: Fama, Eugene and Kenneth French (1988): Dividend yields and expected stock returns, Journal of Financial Economics, 22, 3-25.
3: Janes, L. (December 2018): FTSE 100 yields 4.9% with UK dividends set to hit an all-time high in 2019 Shares Magazine
4: Credit Suisse Global Investment Returns Sourcebook 2015.
6: Wigglesworth, R. (June 2019): Value of negative yielding debt hits record $12.5tn Financial Times
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