For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
In this our second in our series on investing for retirement income we discuss portfolio construction for an income focused fund and why we see income as the output not an input.
Most fund managers running income strategies conceive of income as an investment style, they believe that by favouring higher yielding shares, that may give them an investment edge over time. That has certainly been true for various periods in the past, although in recent years growth has been the dominant style. With growth outperforming income for an extended period, even income managers tended towards a greater growth bias, and the Investment Association (IA) obliged by reducing the income requirement on the income sectors.
When running the Premier Miton Cautious Monthly Income fund we do not see the job as running a fund with a bias towards higher yielding shares and bonds. We certainly do not target a yield for the fund. We see income as the output on the fund not an input. The output we are seeking is not yield per se but an income stream that grows in line with inflation over time.
This allows us the flexibility to invest in any asset class or region to meet the fund’s overall objective, so long as the income and risk requirements are met. We do not even limit ourselves to equities and bonds and are happy to include such assets as commodities, even though they do not pay any income.
Over the past decade or so this flexibility has served us well as growth as an investment style has been performing well, while income has lagged. By having the flexibility to invest in growth sectors and themes we have been able to earn positive capital returns while still generating income. Indeed, it is difficult to grow the income stream over time if the capital value of the fund is not also growing for obvious reasons.
Going forward we do believe now that bond yields may be at more normal levels and inflation is back to stay, income as a style may again perform well. The previous decade or so was highly abnormal, particularly post global financial crisis. Rates were held abnormally low, and inflation was not an issue. This led to an environment where bonds and equities became negatively correlated and yields consistently fell. Portfolio construction in this environment was relatively straightforward: combine growth equities with long duration bonds and all is well, during weak equity environments your bonds might bail you out.
A different approach is required
Now markets are back in a more typical regime, equities and bonds are positively correlated and weak equity markets are more likely to be associated with periods of higher inflation, rather than deflationary recessions. In this environment a different approach may be required to construct an income portfolio.
Bonds are no longer a hedge to equity, although they do have a role for income. The better hedge would be inflation beneficiary assets such as oil and commodities, as well as hard asset-based businesses in equity and property. Combining these with our growth themes equity may be be a less volatile strategy going forward than the more recently favoured 60/40 equity bond mix.
The positive side of this is that in this more inflationary environment, income as an equity style may perform well. Income generating equities are often in sectors that benefit from inflation, which have in most cases fallen out of favour in the past decades. Energy, materials, industrials and property all spring to mind as both good income generators and also good inflation beneficiaries.
History would suggest that if current conditions persist that not only may a growing income be an important demand from clients as inflation bites, but that income strategies may perform well compared to the recently favoured 60/40 and growth biased approaches. Portfolio constructions may need to adapt, but this could very much favour an unconstrained income style.