With all the fuss around the fortunes of UK equity income managers, particularly Neil Woodford’s eponymous new venture, there has been little talk about how funds are delivering on their prime objective, income.
As has been widely covered in the press, several high-profile funds in this sector have failed to deliver on their objective of in excess of 110% of the FTSE All Share. With the index yielding 3.32% as at end of May, investors are likely to be disappointed.
Combine this with underperforming bond markets, and it is clear that wealth managers need to work much harder to satisfy their clients’ yield requirements. This may explain the current popularity of commercial property funds but, as has been the case in the past, many remain nervous about liquidity in the sector, while numerous listed vehicles are trading at unappealing premiums.
The new guard
For Gary Potter, co-head of F&C’s multi-manager team, which includes its income-focused MM Navigator Distribution fund with a prospective yield of 5.1%, a combination of UK equities, bonds and commercial property is an “old-fashioned” approach.
He uses the analogy of hunting for fossils on the UK’s Jurassic Coast. “If you just turn over a few stones, you won’t find any fossils,” he says. “But if you turn over more stones, you might find some. Similarly, when you are looking for income you really have to go out there to find it. “There are some good asset pools delivering sensible yields and, in many cases, premium yields available in conventional income routes.”
The F&C MM Navigator Distribution fund has a fair weight to lesser-known funds in non-mainstream asset classes, including GCP Infrastructure Investments, yielding around 6.5%, and Darwin Leisure Property, a Guernsey-listed, open-ended fund investing in leisure park facilities, yielding 6%.
Others include MedicX, which invests in government-backed GP surgeries; Carador Income, which invests across collateralised loan obligations and yields about 10%; and Blue Capital Global Reinsurance. Potter is less keen on mainstream commercial property funds, believing there are “too many moving parts”, such as investor flows, questions over tenure and cashflow.
“Property is not the obvious place for yield-seeking junkies as valuation gaps have not closed significantly.
In some cases, assets are expensive both at a property and a fund level.
“Sometimes you are paying premiums in the listed space to an asset class that yields 4.5% to 5%, which can be dangerous. The tailwind is certainly there in property but you should look to reduce your London property exposure and move to the regions where there is better value.”
Toby Ricketts, chief executive at Margetts Fund Management, feels property is “a symptom of overvalued bond markets”, with investors taking a renewed interest in the asset class simply because fixed income is failing to deliver a meaningful yield.
He says: “[Open-ended] property funds have massive bid/offer spreads – around 7% at the moment. If we buy in today as a multi-manager on scale, when we try to sell out of it that manager will probably move the price 7% against us. We need a lot more upside before we can accept that sort of risk.
“Property is an illiquid investment though property funds purport to be liquid and, from time to time, there will be liquidity issues when hot money flows in and tries to get out again.
“The risks in property are greater than ever before because a lot of advisers are now running model portfolios and using property funds. The ins and outs of property funds used to be more random when things were more bespoke. Today, when a few
IFAs decide to leave property and take their money off the table, that’s going to trigger a move to bid, which will in turn encourage others to sell.”
Bang to REITs
Of course, open-ended funds are not the only way to access property, nor are investments in bricks and mortar. Svitlana Gubriy, fund manager in Standard Life Investment’s global real estate team, talks up the value of real estate investment trusts (REITs) in combining “the yield-generating characteristics of an asset-backed, fixed-income alternative when bonds are in favour, with the attributes of dividend growth-paying stocks when the focus shifts to economic growth and equity opportunities”.
Gubriy says, as we move through the economic cycle, the ability of REITs to grow dividends is garnering as much attention as their ability to sustain them. “Over the past nine years, the sector dividend distributions have been growing at an impressive6.2% on a compound annual growth rate,” she says (see chart above).
“After dividends rose by more than 10% in 2013, the market expects dividends to rise another 9% in 2014 and with an additional 4.8% in 2015, according to consensus estimates.”
At the margin, property has made its way into many popular multi-asset funds, including Fidelity Multi Asset Income. Manager Eugene Philalithis considers it as more of a growth asset because of its pro-cyclical capital behaviour and inflation-linked income. Still, he stresses it is important to recognise the split of returns between income and capital varies depending on geography.
“To achieve a higher yield, you need to look beyond the major cities to achieve high-quality income from high-quality buildings,” he says, suggesting the domestic market may still offer opportunities for yield seekers. “In the UK, the property market tracked behaviour in the bond sector up to 2009, when an unusual pricing dislocation opened up. Since then, unlike in bonds, values outside the AAA prime markets have been falling until recently, meaning yields have been rising. Non-prime yields have now risen to such an extraordinary degree that, according to CBRE, the premium over 10-year gilts was 887bps in September 2013.”
Like Potter, Philalithis looks to infrastructure for its stable dividend yields, inflation protection, low correlation to equities and government backed revenues with low exposure to the economic cycle. He also picks out the floating-rate secured/leveraged loans sector, defined as bank borrowing to non-investment grade companies to finance mergers and acquisitions, leveraged buyouts, recapitalisations, capital expenditures and general corporate purposes.
“The loans pay a floating rate, earning a base rate – typically LIBOR – plus a spread, meaning if interest rates do rise, the income from these bonds will rise in tandem,” he adds.
“While loans have a similar risk/ return profile to high-yield bonds, the asset class can be lowly correlated to high yield and therefore provides attractive diversification benefits.”
Old-school strategies
There are investors who prefer traditional assets, and Ricketts warns that, amid low base rates, those targeting income over 5% are likely to be taking on too much risk.
“You may be converting capital to income, which in a client’s hands is poor as the income is often taxable and capital loss can’t be offset. You shouldn’t take risks with income portfolios because excessive volatility is the last thing these investors need.”
He says the best sources of income at present are short-dated corporate bonds and equities, with his Providence Strategy generating about 3%.
“Historically, that is a low yield but against cash if we yield 3% and maintain the capital value, or grow it, and give 6x the current interest rate on cash, we don’t feel short of income.”
For those that still prefer equities for income, do decent yield opportunities outside the FTSE 100 behemoths remain? For Gervais Williams, who helms Miton’s UK Multi Cap Income and UK Smaller Companies funds, as well as its Diverse Income Trust, yielding about 3.5%, attitudes to small cap have changed dramatically.
“There has been a complete culture change; whereas small caps have traditionally been for growth-focused investors, solid dividend growth has now become a priority,” he says.
“Small cap is not just about the domestically focused, either. In the AIM market there have been lots of IPOs with international companies coming in. For example, Plus500 is an Israeli company that has little to do with UK except that it is listed here – and it had 8% to 10% yield on issue.”
