Income portfolios jump up the risk spectrum

Intermediaries are being urged to focus on total returns as the low-yield environment pushes income portfolios into higher risk categories.

Photo by Denny Luan on Unsplash

Distribution Technology has bumped two portfolios into higher risk categories in the last quarter. Although it moves portfolios between risk categories regularly, it is the first time it has shifted income funds, says its head of asset and risk modelling Abhimanyu Chatterjee.

“The ones that have been pushed up have been pushed up for two reasons. The first is that they’ve moved into high yield and emerging market bonds. The second is that they’re shifting away from bonds and into the equities space,” Chatterjee says.

He could not reveal which portfolios were bumped into higher risk categories.

Distribution Technology profiles 126 income funds with risk categorisations between four and seven. They represent approximately a tenth of total portfolios profiled by the risk-rating agency.

Chatterjee attributes the shift up the risk spectrum to more volatility on the end of easy money from US, European and UK central bankers.

He expects more income portfolios to be bumped into higher risk categories, stating many are “pushing the upper boundaries” of their existing risk category.

“There will be some income funds who will rebalance, who will take the total return view. They will stay in their risk profile and rebalance the risk. But there will be others that won’t do that and will have to be moved up,” he says.

Risky business

Last month, several asset managers launched reports detailing why natural income investing is becoming increasingly risky.

Searching for yield can suck investors into putting capital at risk over the longer term, says Portfoliometrix UK investment director and portfolio manager Nic Spicer.

The discretionary fund manager published a white paper, Yield of Dreams: can you live off natural yield?, in June warning against the long-term implications of favouring a natural yield approach to investing.

It tells advisers a total return approach results in more diversified and tax efficient portfolios.

It follows the publication of a Royal London Asset Management white paper last month, which argued investors should favour unit encashment over natural yield.

Morningstar data shows funds in its allocation category hold £2trn assets under management via accumulation share classes and £524m via income share classes. The proportion of flows into income share classes has been even lower in the last 12 months, attracting £2.6bn net flows compared to £17.7bn into accumulation share classes.

In favour of income

But Peter Elston, from value investing firm Seneca Investment Management, stresses income is still important.

“The danger of dropping a focus on income is that you end up focusing on an investment style of growth investing, which over time has underperformed,” Elston says.

“If the companies know that investors place a high degree of importance on dividends, it means that they need to be really focused on their capital management and really make sure they’re looking after their shareholders and focused on what they do with their retained earnings.”

The Seneca Diversified Income fund seeks to target a 5% yield.

“As the cycle progresses and markets go up, yields come down. If you’re targeting a fixed 5% yield what do you do? We’ve wanted to reduce overall equity risk, but in order to maintain the income generating capacity we’ve started using an enhanced income fund.”

At the beginning of 2018, the fund added the £123.7m Insight Enhanced Income Booster fund, which uses call overwriting to generate a yield of approximately 8%.

Spicer agrees income is an “extremely important part of returns”. “But the mistake you can make is to focus too much on it and ignore capital gains,” he says.

Chatterjee says a natural income approach may still work for some clients.

“If they have got a £5m pot they can live of 2%. But the Average Joe will have to sell down units and have some income associated with it,” he says.

UK income bias

The UK has the highest number of income funds per capita, according to Chatterjee.

Income investing is “hard coded into the psyche” in the UK, says Spicer.

“Regulation is a component of it and the accessibility of investing in different asset classes. It also used to be much harder to get exposure to overseas equities and other asset classes like absolute return.”

Before 2001, the UK Charity Commission required charities to only spend the natural yield of their investments. And until 2014, they had to obtain an order to take a total return approach to investing. The Trustee Act was also very prescriptive before it was updated in 2000, says Spicer.

The Portfoliometrix paper points out yields on 10-year gilts peaked at 15% in 1981 and at the start of 2018 stood at 1.2%.

“Inertia is dangerous because markets are consistently changing. Just because something worked in the past doesn’t mean it will continue working in future,” says Spicer.

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