“It’s a matter of layering different types of strategies to achieve your goals, because the future will do what the future will do, and no one approach is always going to have the best outcome.”
Kathy Cave, a portfolio manager for Russell and the manager of the Russell Australian Enhanced Income Equity Fund, says the approach to managing an income product is different from managing a product for someone still in accumulation mode.
“Some managers use core-plus strategies, which may include an investment offshore, which is typically hedged, as well,” Cave says.
“If the currency changes, you may need to put some money towards your hedging costs and that may gobble up some of your income.
“The fund we have designed for income doesn’t have those kinds of strategies.”
‘Bonds get you some capital gains, but you also have the risk of capital loss’
Ben Moore, a regional manager with Russell, says there is clearly rising interest among financial planners for better and more flexible income product solutions.
“Definitely we are seeing an increase in requests from advisers for conservative and conservative-like funds, as well as those with an income [focus],” Moore says.
“I look at the ABS data, and we’re seeing more and more people looking to retire every year and for the next 15 years.”
Moore says there’s a greater level of specialisation by planners, too, and among those who are focusing on the pre- and post-retirement market there’s a growing clamour for better ways to address their clients’ income needs. If Hildyard’s assessment of the behavioural characteristics of retirees is correct, then managers face the daunting challenge of producing products that generate attractive levels of income, with limited volatility and downside risk, and the prospect of some capital gain.
Angus Crennan, an investment specialist with Zurich Investments, says it’s possible to achieve all those objectives in one fund. And what’s more, the asset allocation and investment strategy of such a fund does not necessarily need to change when an investor moves from accumulation phase to decumulation phase.
In October this year the Zurich Equity Income Fund will turn five years old. Crennan says that over that period the fund has met its objective of delivering a 10 per cent running yield. At the same time it has provided some downside protection, and delivered a conservative level of growth.
It achieves this performance by investing in high-yielding blue chip Australian shares and using intelligent options strategies to both generate additional income for the fund (in addition to dividend income and associated franking credits) and protect its capital.
The tradeoff is that a reduction in overall volatility means a reduc- tion in upside volatility, too; the price an investor pays, as it were, for receiving an attractive and reliable income stream is that they will not always benefit fully from a strongly rising market.
The effect of the options strategy, says Crennan, is to effectively take the volatility associated with equities and swap it for income. In ideal circumstances, the fund buys equities and sells covered call options; depending on the strategy chosen, the income it receives can then more than cover the cost of protective put options, which place a floor under the capital value of the share component of its portfolio.
The portfolio must be actively managed – it is managed for Zurich by boutique funds management firm Denning Pryce – because it’s not as simple as just buying a share and then selling a call option and buying a put option every single time.
Crennan says the characteristics of the fund address some of the shortcomings in earlier income-producing strategies.
“Bonds get you some capital gains, but you also have the risk of capital loss,” Crennan says.
“The global financial crisis (GFC) has reminded us that credit can exhibit equity-like characteristics.
“I’ve seen some strategies for investors that are going to return the final coupon and your principal in a known period of time. So short of default risk, an investor will intend to consume the principal and the income to live off. As the investor now has known cashflows coming up, they can allocate a part of their capital to growth assets; because they now have time before they need to consume their growth assets, the volatility doesn’t worry them as much.
“I am not talking about a structure where you use a fund manager to blend asset classes. That’s very feasible; you could use an asset manager that’s going to take long/short positions, or could invest in bonds or in other strategies.
“What I’m specifically talking about is a cashflow strategy based around the cashflow certainty of bonds, assuming there is no default by the bond issuer. You are investing in the bond with the deliberate strategy to hold it to maturity to receive back the coupons along the way, and then you intend to consume that principal.
“In Australia we have a wholesale bond market…and ‘retailifying’ it is quite a diffcult challenge. Even if you could invest like an institutional investor, and you were able to take six or eight bonds to put together a portfolio that was going to [provide] you cashflows for the first X period of your retirement, and then you were comfortable to invest the residual part of your portfolio into growth assets such as the equity market, you’ve still got no capital growth from the bond part of your portfolio, because you’re holding the bonds to maturity.
“A reasonably recent development was, I don’t know if you can call them the ‘first generation’ of equity income funds, but what they targeted was high-yield shares. So these are cash cows, if you like – very, very good businesses that are either significant players or dominant in their markets, have healthy margins, and you’re not focusing so much on their earnings per share growth, you’re buying them because their operating cash flows are attractive and their dividend yields are high and sustainable.
