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How investors can meet the income challenge

 
Iain Barnes
There are only so many stocks whose dividends are attractive and predictable enough for an income manager (Source: Shutterstock)

Wealth managers should take a rounded approach to building portfolios, especially if the aim is to provide an ongoing income for the future.

Investors’ ambitions can typically be classified as one of two broad goals: accumulating and growing a pot of money for use in the future, or investing to provide ongoing income, such as a pension or for meeting the costs of education or care. For the latter, we often hear that when faced with future cashflow requirements from their investment portfolios, people only want to invest in income-oriented strategies. We think the implications of doing so are misunderstood and that there are better ways to achieve your income outcome.

The pitfalls of income funds

Portfolios designed purely for income necessarily focus on a narrow set of opportunities – there are only so many stocks and bonds whose dividends and coupons are attractive and predictable enough for an income manager. The risk is that income funds become too concentrated in similar assets and may miss out on better returns elsewhere.

Equity income strategies have become more popular in the last decade as interest rates have declined. Meagre returns on savings accounts have driven people elsewhere, and income funds have regularly topped the best-selling fund lists in recent years. According to Morningstar data, in 2007 specialist equity income funds only made up 1 in 5 UK equity funds marketed to UK individuals. By 2016, this had increased to more than one third.

One third of available funds had an income focus in 2016.

This insatiable demand for income assets has had two results. Firstly, many stocks with secure dividends have become overvalued. Even stocks with seemingly boring, secure cashflows become risky when bought at a premium price. Secondly, many income portfolio managers have to ‘stretch’ further up the risk spectrum to meet their yield targets, resulting in exposure to progressively higher risk assets. The benign prevailing market environment has not yet tested this shift. As we all know, past performance is not a guide to the future.

For portfolios subject to tax, a focus on generating income is often an inefficient way of earning returns. This is especially true for higher and additional rate taxpayers, where income tax rates are well above those for capital gains.

A balanced portfolio is the smarter solution

A better alternative is for wealth managers to take a more rounded approach to building portfolios. An emphasis on the total return from a portfolio means it isn’t restricted to chasing potentially expensive income assets; the manager can be agnostic as to whether returns come from dividends, interest or capital appreciation, allowing for more drivers of portfolio performance.

Importantly, smarter technology at modern wealth managers enables clients to design a personally tailored cashflow strategy with ease, and funded from different portfolio components. This provides the opportunity to match payment requirements precisely, rather than rely on forecasting a portfolio’s expected yield. We believe that combining this with the improved tax efficiency and a more balanced portfolio targeting total returns, is a much better approach for those who are seeking income.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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