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MIND THE GAP

Be discerning on funds' income payouts

When your fund generates a payout, is that all coming from the portfolio's dividend yield or income?

INVESTING with a view to generating income is a key building block for long-term portfolios.

As bank interest rates remain paltry, portfolios will need to yield an income, not only to juice up total returns, but also to help supplement the income of savers and retirees.

But not all income is alike, and it is important to be discerning as to the risk that accompanies the income. Many investors have come to grief chasing investments with purportedly high income payouts, but they suffer permanent loss of capital in the case of a bond default, for instance, or worse, a scam.

Based on Morningstar Direct data on equity income funds, the income or dividend portion of total returns has been historically high for some funds - well over five per cent. The Allianz Global High Payout Fund, for example, generated between 7 and over 10 per cent in annual income return between 2008 and 2016. This has since moderated to around 5 per cent. Morningstar defines income return as the portion of the holding period return attributed to dividend distributions, and is assumed to be reinvested.

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Schroders' Maximiser series of funds, managed on a strategy similar to the Allianz Global High Payout Fund, has an average payout yield since inception of 7.2 per cent for the Asian Dividend Maximiser Fund, and 8 per cent for the Global Dividend Maximiser Fund.

Here are a number of things to keep in mind on income investing.

Stay invested; volatility is par for the course.

The degree of volatility in income funds will of course depend on the size of exposure to risk assets. Rupert Rucker, Schroders head of income solutions, says the only option with no capital risk would be bank deposits. But that would get you nowhere in terms of savings goals.

Schroder's income products fall broadly into three buckets - 3-4 per cent in income; 5-6 and 6-7 per cent. "They are different solutions and all entail risk with your capital. There is no way we can protect your capital and provide a meaningful level of real income. One of the biggest risk is time, not volatility. If you panic because of uncertainty, you crystallise your position. If you can maintain your investment, you will compound the returns you receive."

Funds in the 3-4 per cent bucket comprise equity income funds. Yields on the global equity market average around 3 per cent. Funds in the 5-6 per cent bucket - which Mr Rucker refers to as the "sweet spot" for investors - are generally multi-asset funds. Those in the 6-7 per cent bucket comprise higher risk credit, for instance, or emerging market assets; or funds such as the Schroder Maximiser series that earn an extra income from a call option overlay. More on that shortly.

Low for longer

The level of interest rates today suggests that appetite for income is a theme that is unlikely to fade anytime soon. The flip side is that demand for income could spur investors to seek yield from higher risk assets whose risks they may not fully grasp. Mr Rucker says in the current late-cycle environment, most markets and asset classes are fully valued. "The difference this time is that we think rates will remain persistently low. In 30 years' time we think rates will be quite similar to where they are today. That's quite a bold statement, but it means that to generate income, you have to be very careful what you pay for the underlying assets. You have to understand how much you pay and how risky it is. That has always been the case but it is much more important going forward."

Schroders has published a paper, "Inescapable investment 'truths' for the decade ahead''. It posits, among a number of points, that the level of interest rates over the next decade would be similar to the average rate between 1900 and 1981, about 1 to 3 per cent below pre-crisis levels.

Funds such as Schroders' Dividend Maximiser series and Allianz's Global High Payout fund illustrate the need to fully understand the payoffs in a fund that pays a high dividend. In addition to dividend income, these funds also have a call option overlay - that is, the fund earns a premium from writing a covered call option. Writing a covered call option means that the fund sells the right to buy a stock/s that the fund owns, at a specific price and within a specified time frame. The fund earns a premium from the call option, but it sacrifices the upside from the stocks which form the underlying asset for the option.

In a rising market the strategy is likely to underperform, but it should outperform when markets are stagnant or falling, thanks to the extra income generated by the premium from the options strategy.

Income or capital?

When your fund generates a payout, is that all coming from the portfolio's dividend yield or income? Or are you actually getting a portion of your capital back in the fund's effort to maintain a level of payout? Managers are required to disclose the composition of a fund's payout, but for some firms that data is not easy to extract. Schroders is among the most transparent, as it publishes a statement available online to reflect the composition of distributions for all its funds.

Mr Rucker says a good indication of whether you are receiving a dividend or your own capital is the fund's "natural" level of income, or the portfolio's underlying yield. "If (the portfolio yield) equates to what is distributed, that's fine. What you don't want is when fund doesn't yield as much as it pays out."

Here's an example of some funds with relatively high payouts. The Allianz Global High Payout Fund, for instance, has a dividend yield of 5.22 per cent. The portion of return attributable to income in 2018 was 4.78 per cent, based on Morningstar data. Payouts are made on a semi-annual basis. As at the record date on Dec 12, 2018, 100 per cent of the payout was out of distributable income.

Says an Allianz Global InvestorsĀ spokesperson: "Our objective is to set a payout level that is sustainable. At the firm level our approach is to regularly review the payout levels of each fund for sustainability and appropriateness to the product and investor needs.''

The United Asia Pacific Real Estate Income Fund has historically maintained fund distributions of 5 per cent a year since 2014. Of the distribution, 4.1 per cent comes from the portfolio yield and 0.9 per cent from realised gains. The indicative portfolio yield as at March 2019 is 4.1 per cent.

For Schroders' equity income funds, such as the Schroder Asian Income fund, the intention is to pay out completely from dividend income. "However, in the event that the fund's income and realised gains are less than the indicated payout rate, distributions will be made from capital, subject to trustee approval. We review our payout rates regularly and will adjust them accordingly."

The Schroders Asian Income fund's average payout yield since inception is 5.6 per cent. It pays out a monthly income. Based on the monthly distribution breakdown, there are some months when some proportion of distribution is paid from capital gain.

JP Morgan Asset Management's Global Income A Fund has an annualised distribution yield of between 4.41 and 4.77 per cent, based on distributions made between December 2018 and March 2019. It makes a monthly payout. The estimated running yield of the portfolio's underlying assets is 4.38 per cent as at end February.

The firm's spokesperson said: "A core part of our philosophy is to use a balanced approach when determining the distribution yield. The intention is to only pay out the distribution based on the running yield of the portfolio and not from capital gain, which we believe is a more sustainable way to receive income.

"We do not have a yield target as we do not want to be in a position where we are forced to take excess risk to achieve that yield for our clients."