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.
Volatile and unreliable?
As we have written regularly there is a lot of interest currently in the use of income producing funds for post-retirement clients, as an alternative to annuities or as the core of a centralised retirement proposition. One of the more common criticisms of this approach is, that income from ‘income’ funds can be volatile and unreliable.
Income as an output
We very much agree with this critique. Many funds successfully pursue income as an investment style, to take advantage of the lower volatility and attractive valuations of companies with higher dividend yields. This is an attractive approach that may outperform now the era of quantitative easing (QE) and ultra-low inflation has reverted to normal. This is very different, however, to seeing income as an investment product. Income in this case becomes the output, the objective, rather than an input. It is not a criticism of income managers that their income is volatile, it is simply a misunderstanding. These managers see income as an input into the process, just like a US manager buys US stocks, income managers buy stocks with incomes (mostly).
Other managers target a yield level for the funds they run, either in absolute terms or relative to a benchmark. Again, this is fine, but might not be what a post-retirement client is seeking as the income will go up and down with the markets in a target yield fund.
We see income as the product of our investment process. We focus on maintaining and growing that income level over time ahead of inflation. To do this we need a process to manage the income in addition to our fund management process.
Management intervention
Income management is a particular skill which the industry has largely forgotten over the past few decades. A further level of effort is required to achieve the desired goal of a growing income stream. The manager needs to understand not only the yield on his portfolio, but when that income becomes available to be distributed.
A common practice amongst fund managers is to quote the investment yield on the fund, when asked about yield. In the case of an equity fund this would be the portfolio yield on a certain day, based either on the dividends paid by companies currently held over the past year, or in the future. This can be very different form the dividend received by unit holders, depending on which shares go ‘ex-dividend’ in the period, tax rates and charges that a made against income.
The same is true for bond portfolios, managers typically quote a gross redemption yield, which is a total return figure, if the portfolio is held to maturity. Again, this is very different for the coupons received which can be distributed as income. Right now, bond managers are prone to quote very high gross redemption yields, reflecting the falls in bond prices to below par value, but future total return will comprise a mix of capital gain as well as income. The cash received by unit holders as income will be much lower. Maturities will be reinvested at gross redemption yields and income yields that may be quite different from current yields. Again, the gross redemption yield quoted is potentially very different from the income unitholders receive and the total return.
Consistency of income
To manage the income in a fund, the manager needs to be very conscious of these differences and learn to exploit them to his clients’ best interest. At the same time, he will need to forecast future dividend flows and be aware of the impact of bond maturities and calls. In the case of our fund that pays a monthly income, this requires a detailed day by day forecast of the income flows into the fund, and a constant look ahead. As we have written before we think this extra work benefits our clients in terms of the consistency of income but, additionally, may lead to superior total returns as the discipline encourages better decision making.
