Glen Copans, Chief Investment Officer: Investec Specialist Investments
Loose monetary policy and fiscal stimulus remain a key component of developed market policies as the world navigates the pandemic, meaning risk assets may remain in demand. Income funds, however, still have a role to play in a portfolio.
All eyes were on Finance Minister Tito Mboweni last month as he tabled the 2021 Budget. South Africans were looking for the easing of tax measures to help boost domestic and foreign investment and stimulate economic growth in a post-pandemic environment.
The impact of the Budget and the dynamic environment are, however, not limited to large institutional investors. They’re equally relevant to private clients and retail investors who are struggling to balance risk and income in their investment portfolios.
The Covid-19 pandemic drastically changed the local and global investment landscape. Strict lockdowns collapsed demand and slowed economies to a sluggish pace. A loosening of monetary policy drove short-term rates to all-time lows. Investors may still be earning a real return on their investments through income funds, however, they are not at the absolute level that they were before inflation and rates fell. Loose monetary policy and fiscal stimulus remain a key component of developed market policies, as the world navigates the pandemic. This means that risk assets may remain in demand, at the possible expense of income funds. Any concomitant rise in inflation may also put pressure on the income fund segment of the market, especially with short-term rates expected to remain low for the foreseeable future.
Despite these changing dynamics and the rising appetite for risk assets, income funds and similar funds are still prioritised by investors looking for consistent and enhanced returns with relatively low risk, within a balanced portfolio construction.
INCOME FUNDS OFFER LOW-RISK RETURNS IN VOLATILE MARKETS
Income funds have been a popular investment strategy due to their dependable, low-risk return, especially when compared with general equity funds, which up to last year have had to contend with a sluggish local equity market.
Market dynamics can change quickly, however, as we saw last year. This is why investors need to regularly reassess their holdings and the underlying forces that drive their returns , for signs of change. Black Swan events, similar to that which we have experienced in the last 12 months, require a reassessment of the dynamics.
The market dislocations of March and April last year were a novel experience for many income fund investors. With the instantaneous and significant widening of credit spreads, coupled with the simultaneous steepening of the yield curve, fixed income assets fell significantly. Despite income funds having low duration exposure, the allocations resulted in negative returns for the majority of income funds, with many funds delivering their lowest monthly returns to date.
Although losses have subsequently been clawed back with normalisation of both credit spreads and interest rates, investors have seen that this class of funds is not immune to volatility or negative returns. The majority of income funds do not take large fixed rate exposure, with the expected yields being highly correlated to interest rates, as evidenced by the concurrent reduction in the absolute yield. The relative outperformance of the underlying assets, however, which continues to deliver around 2% above cash, is more pronounced in the current low interest rate environment.
This level of outperformance remains compelling, as it continues to yield real returns above inflation, despite the lower absolute yield. The selective use of credit instruments including banks and corporate credit, drawn from an expanding investable universe is a way for income funds to enhance returns. Another is to increase duration, given the steepness of the current yield curve, specifically through investment in government bonds. This offers an opportunity to earn returns in excess of inflation, despite this being a crowded trade in recent months.
DIVERSIFICATION CAN HELP YOU WEATHER THE STORM
The increasing diversification of investment strategies employed by income fund managers has led to greater dispersion of returns between funds, albeit that the majority have managed to produce real returns despite the volatility and low-yield environment. Different sub-asset classes within the Income space, such as credit, can help a fund manager to achieve these diversification goals. Consequently, investor interest persists, as is shown by the continued growth in the income sector dominated by a few large funds. We’ve seen a further diversion from cash investment allocations as investors better understand the risk return dynamics of the fixed income asset class under different market conditions.
New generation income-type investments may also fulfil a role in an income fund through so-called yield companies (yieldcos), whose distributions are tied to underlying contract income. Good examples include yieldcos that invest in renewable energy projects or those where income return is derived from preference shares or real estate investments. In addition, the expansion of income assets to include global opportunities is both providing further diversification and enhancement to the portfolio construction process. Persistence in performance should always be an important consideration for income fund investors. Typically, investors will want the comfort of knowing that funds that have delivered in the past will continue to do so in future. This is of particular relevance for income fund investors, for whom a reliable source of income is paramount. Persistence in the underlying instruments, achieved through a reduction in market risks by the investment manager, leads to greater certainty of the outcomes and less variability in returns. Compare this with, for example, general equity funds, where a degree of volatility can be tolerated in the short term, so long as growth is delivered over the long term.
Investors should therefore pay particular attention to measures such as dispersion of returns around the benchmark and maximum losses experienced through an appreciation of volatility, alpha (fund performance relative to its benchmark) and return drawdowns. In addition, qualitative criteria such as changes to portfolio managers, their investment strategy or philosophy, should also receive attention, given the conservative nature of the asset class.
The key focus, however, remains on managing the risks. If fund managers can control volatility and any potential capital risk, then allocations to a broader range of instruments can help investors to deliver consistent enhanced returns within a diversified portfolio.