What Makes A Good Income Fund Great?

Income generating mutual funds and exchange traded funds should be the cornerstone of any retirement plan. Later in life, investors are more likely to prioritise capital preservation and income generation than capital appreciation. By focusing on dividends, bonds and rental properties, income funds fulfill this need perfectly.

However, picking the right income fund is nearly as tricky as picking stocks. Investors need to take a look under the hood to understand how a particular income fund is managed, how the portfolio is constructed and where the income is generated. Here’s a brief overview of all the factors that make a good income fund great:

Credit Quality

The relative quality of credit assets is, arguably, more important than the income yield. Corporate bond issuers run the risk of defaulting on their debt, which has a direct effect on the income funds that hold these instruments. Ordinary investors can’t judge the credit quality of their income funds independently, which is why most rely on credit ratings issued by agencies such as Moody's or Standard & Poor’s. However, based on facts that emerged during the financial meltdown of 2008-09, these ratings are best taken with a grain of salt (The Credit Rating Controversy, CFR, February 19, 2015).

Fees

Another critical factor is the expense ratio of income funds. Considering the single digit yield most UK income funds offer, every basis point in fees can have a drastic impact on wealth compounded over decades. According to Morningstar (Jackie Beard, FCS, 23 October, 2018), the average fee for actively managed bond funds fell by 10% since new financial regulations were introduced in 2013. However, exchange traded funds or ETFs were still cheaper than actively managed income funds.  

Cyclicality

Picking the right type of income fund depends on the business cycle. All income funds can be described as either Growth, Defensive or Uncorrelated. Growth funds such as high-income debt funds perform better when the market is expanding, while investment grade corporate and government bonds outperform during a recession which makes them ‘defensive’. Uncorrelated instruments, such as insurance, provide a stable return regardless of market conditions. Picking the right type of income fund boils down to the investor’s preferences, risk tolerance, and long-term objectives.

It’s important to note that these factors may help investors pick an income fund traditionally deemed as ‘high quality’, but they cannot predict performance over the long term. In fact, research published by Morningstar (Performance Persistence Among U.S. Mutual Funds, January, 2016) showed that the correlation between short-term and long-term mutual fund performance was negligible. This implies that past performance shouldn’t be used as an indicator of future results.

Instead, by focusing on investment-grade, low-fee income funds in recession-proof sectors, investors can mitigate the effects of inflation and preserve their capital for the long run.  

The value of investments and income from them may go down as well as up and you may not get back the original amount invested.

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