Income funds can cover a multitude of strategies, investments and levels of risk. When it comes to investing safely and sustainably, knowledge is everything. Here are five questions to ask before deciding if your income fund is doing what you want it to.
1.How does it fit into the rest of your client’s portfolio?
Like any investment strategy, an income portfolio needs to be properly balanced and diversified. One temptation is simply to invest in a range of income funds from different fund managers. But that’s no good if your chosen funds all turn out to be heavily skewed to the same types of government bond or just the world’s largest companies, especially at a time when major companies have been substantially reducing dividend payments.
Take the time to look under the bonnet and see what a fund holds, and how it might complement your client’s existing portfolio.
2. Do you know what’s in the fund?
To meet the need for yield, a vast variety of income strategies has proliferated, ranging from simple investment-grade bond funds to the most complex of quasi-hedge fund strategies. Before investing, it’s vital to understand what a fund is investing in and its overall philosophy. Alarm bells shouldn’t necessarily ring if a fund contains unfamiliar investments: emerging asset classes such as insurance-linked securities and aircraft leasing can offer attractive income streams with low correlation to more-established income investments.
But a fund’s manager should make it easy to understand exactly how income is being generated. This comes down to the quality and detail of reporting. If you’re struggling to work out how an income fund operates, or what it holds, be wary.
3. Are all underlying exposures titled to generating income?
To work hard on your behalf, an income fund needs a portfolio that’s completely geared to bringing together the most attractive income opportunities available.
In our view, a high level of asset diversification is critical to achieving a strong and sustainable yield, especially in a low-rate environment. The Aberdeen Diversified Income Fund, for example, typically invests in around 25 asset classes at any one time, including property, renewable and social infrastructure, asset-backed securities, insurance-linked securities and high-yield bonds – as well as investment-grade bonds and listed equity.
Using Aberdeen’s first-hand, on-the-ground global research, these asset classes are all selected for their emphasis on long-term income generation and their very different risk profiles. This helps to avoid the portfolio becoming overly reliant on any single economic or market factor to achieve its returns. For example, insurance-linked securities carry almost zero interest-rate risk, which makes them a good counter to rate-sensitive government bonds. Or the cashflows on renewable infrastructure aren’t particularly reliant on a strong economy, which helps to balance out the dividends on equities. These are the type of trade-offs that can help to avoid income shocks.
4. Is the income target sustainable?
To capture the attention of advisers and investors or to qualify for inclusion in a particular income fund sector, income funds may set their target yield high. But the quid pro quo of any investment strategy is the higher the target yield, the higher the risk profile. If a fund is offering a target yield that seems sharply at odds with the current yield on standard bond and equity benchmarks, find out why and how. In some cases it may mean heavy exposure to high-yield investments further down the credit-rating curve or to emerging market debt. Both can have an important role to play in an income strategy – but make sure that the level of exposure is appropriate to your risk tolerance.
Also look at a fund’s performance record to assess if yield is being achieved at the cost of capital growth. Delivering an income that can keep pace with the long-term rising cost of living requires an element of capital growth too, and this can actually make the percentage income yield look smaller. Rather than getting hung up on the headline percentage yield figure, look at what a fund has achieved in absolute capital and income terms. But also remember that past performance isn’t a guide to the future.
5. Does it have sufficient flexibility to be future-proofed?
Ideally, an income fund should act as a long-term core holding in a portfolio – one that you can rely on to tide you through changing market conditions, year in, year out. But that can only happen if a fund has the flexibility to respond dynamically to market events and the changing attractiveness of different asset classes. If an income fund is constrained to a particular market index – or can only invest in a limited range of asset classes – it may struggle to deliver steady income throughout the market cycle (and the last thing an income-seeker wants is a yield that fluctuates too sharply). Right now, for example, funds that are tied to bonds could struggle if and when inflation and, in turn, interest rates start to rise.
Seek out those funds that can adjust the asset mix without constraint so you are always getting the portfolio manager’s very best income ideas at any given time. Such flexibility should also provide more downside protection in times of market stress.