Recently I have been designing the firm’s Central Investment Proposition, and I ran into a perennial question. Where do we go for income these days?
This is a question with many layers, and maybe it is worth starting with something of a history lesson. As such, come with me now on a journey into the past, a journey to pre-2008.
The Way Things Were
I imagine this is where investments came from pre-2008.
Before the Global Financial Crisis, finding income was pretty easy. Annuity rates were high because gilt rates were high, and corporate bonds were paying high coupons. As such, the idea in retirement of simply setting up a portfolio split 50/50 between low-risk income-producing assets and equities for growth. This blend would allow half of the portfolio to provide a steady income at a reasonable level, while the other half would work to increase the value of the portfolio as a whole.
Then the financial world imploded. Interest rates tumbled, gilts and corporate bonds started trading at much higher prices, which reduced their effective income yield, and many companies reduced or suspended their dividends. Property funds became “gated”, restricting disposals because so many people were suddenly averse to the volatility of property.
What was left? Very little. It left a lot of investment professionals scratching their heads to think of something they could offer their income-seeking clients. This ended up with a huge range of open ended funds being formed specifically to generate income, and many of these are the only thing used by advisers to this date.
An Alternative
Those of you who are investment savvy may have picked up on the alternative already from the clues in the last paragraph. If you didn’t, don’t worry – it was quite an oblique reference.
My alternative is in the world of closed-ended funds. These are better known as investment trusts, and they actually predate the open-ended structures that we are familiar with – unit trusts and open ended investment companies. An investment trust is a listed equity that buys other investments. As such, the first thing to consider is what that means for the volatility of the holding.
With investment trusts, the value on a given day is driven by two things, namely sentiment and the underlying net asset value of the holdings. As the underlying holdings are themselves driven by sentiment and some form of valuation, this means that the price can be much more sensitive to external factors on a day to day basis.
So why on Earth would I mention these for an income portfolio, where reliability is paramount?
My answer to this is a simple question: why does volatility matter to you? In most cases, clients looking for an income would be happy with the idea of trading a lump sum to an insurance company in exchange for an income for life – this is known as an annuity. But in this example, the capital is fully depleted immediately, hence the volatility might be low, but the “risk” of loss is extremely high, actually a certainty.
Volatility is one way to measure risk, but it is not the only way. In fact, my preferred risk metric for growth assets is maximum drawdown, which shows the largest drop from peak to trough in a given timeframe. To me this is better than volatility for two main reasons, namely that volatility captures the upside as well as the down, and also that volatility only tells you about the average performance, not the worst case.
But I digress.
Coming back to investment trusts, I mentioned already that the structure predates the open ended funds we are all probably more familiar with. This means that many of them have a performance history spanning decades, including details of dividends. Some of those trusts have a history of nearly 60 years of rising dividend payments. What’s their secret?
In many cases the secret is easy: investment trusts are allowed to set aside capital in good years for continuing to pay dividends in poor years. This results in many trusts having a dividend cover (the amount of cash reserves they hold as a ratio to the annual dividend) of several months to a year, meaning that if they trust’s investments all stopped paying their dividends, which has never happened, the trust would still be able to keep paying dividends until the cover was depleted.
This means that if we consider the risk of an income-producing investment trust, to my mind it is wholly inappropriate to look at the volatility or the maximum drawdown, as these are not investments that should be held with anything other than the ultra-long term in mind.
As an example, the Income portfolio that I have put together for my clients has the following characteristics at the time of drafting the article:
| Name | 3yr Volatility | 3yr Max Drawdown | Yield |
|---|---|---|---|
|
Aegis Income Portfolio |
12.62% |
-11.47% |
4.53% |
|
Annuity |
0% |
-100.00% |
3.81% |
|
Corporate Bond Index Fund |
8.59% |
-24.46% |
3.60% |
This demonstrates that a diversified investment trust portfolio has similar risk categorisations to the corporate bond index fund, albeit with more volatility (but less drawdown, which as I mentioned above is likely more useful as a measure of investment risk). Compared to the annuity, clearly this represents higher volatility, but 1) the annuity guarantees a loss of all capital and 2) the yield on the investment trust portfolio is nearly 20% higher than that available from an annuity.
The objection here must then be “but what if the dividend stops?” This is an excellent question, but it has a comprehensive answer.
First, the dividend is unlikely to stop because all of these trusts either have significant dividend cover or have a history of raising their dividends regularly, with the shortest track record spanning 20 years of rising dividend payments. Secondly, the diversification across 13 different investment trusts means that an enormous part of the world economy has to be in trouble for more than a couple of the trusts to run into trouble. Thirdly, even if the dividends run into trouble, capital can be raised by selling shares.
Overall, I believe that this type of portfolio, coupled with a sufficient cash reserve for emergencies, is likely to satisfy the needs of more investors than either a corporate bond focused retirement portfolio or an annuity.
