16th June 2023
This week I participated in an income focussed panel debate organised by the excellent Matthew Dewsnap and Gillian Lamb of QuantQual. (If you are an independent advice firm looking for assistance with your investment proposition and due diligence reporting, I’d definitely look them up.) For many investors and clients, taking an income from their investment portfolio is a critical requirement, helping to replace or complement existing sources with the ultimate aim of fulfilling the lifestyle they want to lead. In meeting these requirements investors can either construct portfolios that generate a high level of natural income, or alternatively can adopt a total return approach whereby investments are sold down as required with income effectively paid out of capital. Whilst getting into the pros and cons of each approach from a financial planning perspective is way above our pay grade, we do think that from a purely investment standpoint the former has merit, helping to better control longevity and sequencing risk.
We think this is particularly true at the moment. For a decade or more, up until the end of 2021, growth investing had been the only game in town, with boring income stocks truly out of vogue and the meagre returns available in the bond market serving to push investors out along the risk curve. This myopic focus on racier parts of the market resulted in significant valuation dispersion, with a cohort of growth stocks coming to trade at a significant premium to ‘dull’ income paying peers. Despite a brutal drawdown last year, this valuation divergence remains evident today and combined with a murkier macro-outlook surely increases investor wariness regarding the probability of capital growth coming through in the years ahead. This creates problems for total return approaches that meet income requirements from capital, leaving investors and clients exposed to price volatility and potentially rendering them forced sellers at points of market drawdown. This can result in the crystallisation of permanent losses but even if markets end up being relatively calm, then the size of one’s nest egg is still likely to seep away quickly should growth mean revert and prove to be less abundant than it has in recent years.
It should be recognised that the amount of income generated by a portfolio can be volatile as well, creating potential problems for underlying clients hoping to take a set amount of income on a regular basis. There are, however, a number of ways to mitigate this income volatility. Firstly, it is important to have as broad an investment universe as possible. The income generated by equities and bonds will change over time driven by market conditions. Dividends, for example, were cut across the board in the face of the Covid pandemic, whilst the post GFC regime of low inflation, brittle growth and extremes in monetary policy (zero rates and quantitative easing) resulted in painfully low bond yields. When the income returns from these traditional asset classes disappoint, it is important to have the capacity to look elsewhere. As truly multi-asset investors who make extensive use of Investment Trusts, we are able to access a whole host of less liquid assets by way of alternative asset classes, many of which pay very attractive dividends. This might include funds investing in ships that yield over 10%, diversified property trusts yielding 8% or a portfolio of battery storage projects offering a yield of close to 7.5%.
Reflecting the fact that the relative attractiveness of the income returns available from different asset classes changes over time, we also think it is incredibly important to adopt an unconstrained and dynamic approach to asset allocation and this is certainly something we look to implement in our own Distribution Fund. At the end of 2021, the 10-year gilt was yielding less than 1% and credit spreads were tight resulting in low return prospects and a negatively asymmetric return profile from much of the bond market. Distribution’s exposure to fixed income at this point was at a historic low of less than 12%, whilst our exposure to alternative assets generating attractive levels of income was high at around 29%. What fixed income exposure we did have was very targeted and focused on highly active managers and more niche sectors like low duration structured credit and direct lending where we were still able to harvest decent levels of income. 2022, a year we sometimes refer to as ‘the great repricing’, saw nominal and real government bond yields shoot up across the curve and saw credit spreads expand, materially changing prospective returns and bonds’ relative attractiveness. Being able to capture high running yields via actively managed, diversified and liquid credit funds means that we have become less reliant on Investment Trusts and alternative real assets. Within our Distribution Fund, exposure to fixed income today stands at over 25% whilst our exposure to alternatives is now less than 13%.
The key point here is that having a broad investment universe and dynamic approach helps investors manage income volatility and maximises the probability of maintaining a consistent level of income regardless of the challenges changing market conditions pose. This idea manifests itself in the performance of our Distribution Fund where income, as measured by dividends paid per unit, has been incredibly consistent over the history of the fund despite the precipitous collapse in the risk-free rate that has coincided with Distribution’s life. Ultimately, diversified sources of income and having the flexibility to actively toggle exposure between these different sources is, we strongly believe, key to a successful natural income strategy.
We would also argue that the choice between income and capital is not a binary one. There are plenty of investments available that are paying out handsome levels of income whilst also delivering capital growth. We own a number of income focussed UK Mid and Small Cap Equity Funds, for example, offering attractive yields and exposure to companies with progressive pay-outs underpinned by secular earnings growth. Similarly, there are investments in the real asset space like Gresham House Energy Storage which pays a consistent and fully covered 7p dividend, but which has also delivered material capital appreciation in net asset value resulting in stellar total returns. Elsewhere, index linked leases and active asset management at some of our favoured property plays help drive a progressive dividend as well as offering scope for capital growth. Finally, with many bonds trading below par, most of our actively managed fixed income funds offer attractive levels of income but also high yields to maturity. The ability to capture a balance between high natural income and capital growth potential is again evidenced by the Hawksmoor Distribution Fund, where £100,000 invested at the launch in April 2012 would have generated £55k in income and £39k in capital appreciation.
The benefits of adopting a natural income strategy are eternal but we would argue that relative valuations in equity markets, the repricing we have seen in bond markets and the plethora of income generating alternative assets now available to investors makes the arguments for such an approach all the more compelling today. Importantly, being nimble and unconstrained maximises the return potential and consistency of delivery of this type of strategy.
Ben Mackie – Fund Manager
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