Assets that yield regular above-inflation income have become endangered species in the low interest rate environment.
But the hunt goes on, according to Greg Fleming, Salt Funds head of global diversified funds.
Fleming says in a new paper that while NZ, in particular, has evolved into a “capital gains paradise” there are still “points in the life cycle where a steady cash income stream is very important”.
“Retirement is obviously one such, but also, periods of study, family-member support, and personal incapacity are times when being able to draw a simple stream of cash on a predictable basis is crucial,” he says.
Likewise, Fleming says many wholesale investors such as income-distributing trusts or charities need to find assets that match their cash-flow requirements without unduly risking capital loss.
While many investors simply cash-in some of the capital gains on growth-oriented portfolios or seek out “exotic asset pools”, he says “yield strain” creates challenges for fund managers looking to build traditional diversified income portfolios of liquid assets.
The result has seen fund managers develop income solutions in “a plethora of formats, and the sector is something of a mixed bag, with many underlying asset types and qualities involved”, Fleming says in the paper.
“What is critical, is ensuring that the funds’ manager is skilled at assembling a higher-yielding asset pool that does not compromise on asset quality or on the sustainability of income, but that can still provide a solid stream of distributions to a reliable timetable,” he says.
Despite the difficulties, Fleming says there are seven principles investment managers can adopt to help build income funds to code, including:
- active management is essential for both asset allocation and security selection;
- funds should include global assets;
- don’t promise “return without risk” – learn from historical lessons such as the collateralised debt obligations (CDO) fiasco in the GFC;
- tax efficiency is important in product design (but funds should not rely on particular tax lurks);
- currency management for exposure to offshore assets matters, especially as the traditional “hedging premium” open to NZ investors has now faded considerably;
- some degree of inflation-protection is possibly by investing in assets that have historically outpaced “unanticipated inflation, and which have innate inflation-hedging characteristics”; and,
- keep it simple – over-engineered risk-mitigation structures tend to be “quite expensive”, draining the fund over time and potentially failing when most needed.
“You can’t disguise security risks with clever structures,” Fleming said. “It has to be clear that the price of higher yields involves more risk – which is why it’s important investors have the correct time horizon.”
Salt threw its hat into the income fund market after establishing a new product last December. The Salt Sustainable Income Fund, which only went live last month, targets a mix of Australasian shares (30 per cent), local and global fixed income (20 and 15 per cent, respectively), international listed property (15 per cent), global listed infrastructure (15 per cent) and the remainder in cash.
The fund is offering a current annual distribution of 3.75 per cent (paid quarterly) with “an aim to provide regular income along with a positive return on capital on a rolling three year basis” against a total management charge of 0.85 per cent per annum.
Salt manages local assets in-house while outsourcing to PIMCO (international fixed) while Cohen and Steers manages global property and listed infrastructure.
Global shares are not part of the Salt income fund benchmark portfolio but the manager has appointed Morgan Stanley for the asset class in a range of other diversified products established under the ‘sustainable’ range last December.
Fleming, who joined Salt earlier this year from AMP Capital NZ to head the diversified suite, said the manager had “the luxury of building an income fund from scratch”.
“The asset allocation was designed for the changed world,” he said, where it’s not enough to hedge out equity risk with sovereign bonds.