Investments

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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5 Investment Lessons In Memory of Jack Bogle

“Jack did more for American investors than any individual I’ve known,” said Warren Buffett (CNBC, Jan 16 2019). Last week, investment legend and the founder of Vanguard, John Clifton "Jack" Bogle, passed away at the age of 89. His lasting legacy is the dramatic reduction in fees charged by money managers and mutual funds across the world.

Bogle pioneered the idea of an index fund, a type of mutual fund that passively tracks a major index rather than pick specific stocks to create a portfolio. Since these funds don’t require much management, the fees could be a lot lower than the typical actively-managed mutual fund.

Bogle once summarised the underlying principle by saying, “don't look for the needle in the haystack. Just buy the haystack!” While the idea was controversial at the time, the model has since been accepted as a legitimately effective investment strategy. Passive index funds now account for $8 trillion in assets under management, representing 20% of the total mutual fund industry (Michael Cannivet, Forbes, June 27 2018).

In Bogle’s memory, here are some of his most well-known investment and business lessons:

1. Stay the course

Bogle championed consistency and persistence in investing. Investors, he argued, must hold onto their stocks when the market gets risky (Jeff Sommer, the New York Times, 11, 2012). Long-term investors are helped by the dual effects of compounding and dollar-cost averaging, however investors need a structured strategy to take advantage of these economic benefits.

2. Think independently

A contrarian approach to investing is exactly what led Jack Bogle to indexing while the rest of the financial services industry was obsessed with chasing returns and charging high fees. The business community derided him when he first introduced his index fund in 1976, calling it “Bogle’s Folly,” “a sure path to mediocrity” and even “un-American” (Steven Goldberg, Kiplinger, January 17, 2019). Being able to drown out the noise and focus on his underlying principles helped Bogle eventually revolutionise the industry he worked in.

3. Cut costs

Lowering costs is the cornerstone of the passive investment strategy. Every percentage point of cost savings can be reinvested into the fund that should compound at an accelerated pace over time. If you consider the $8 trillion invested in passive index funds now, every basis point of fees represents $800 million in annual savings. The difference between the average active and passive fund is estimated at 100 basis points (Kent Thune, the Balance, September 06, 2018).

4. Impulse is your enemy

Both good and bad investors have periods of over and under-performance. Investments are a non-linear endeavour and the worst thing an investor can do is act on impulse. Bogle championed a pragmatic approach based on realistic expectations of the future.

5. Culture trumps strategy

One of Bogle’s key principles extends beyond the realm of investing. He was a firm believer that an organisation’s culture mattered more than its strategy. According to Vanguard’s current CEO, F. William McNabb, the company’s culture is based on the late-founder’s principles of hard work, treating everyone with respect, always doing the right thing and putting clients’ interests first. Vanguard now manages over $5 trillion assets for 20 million investors in 170 countries (Shawn M. Carter, CNBC, Jan 18 2019).

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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Where are our home-grown tech giants?

When it comes to technology, it seems the most recognisable companies are more often than not American. Most investors can name the industries dominated by Facebook, Google, Apple, and Microsoft in an instant. In fact, emerging names like Tesla and Airbnb are also American.

Tech names from other parts of the world are quickly gaining ground. In recent years, Alibaba, Softbank, and Spotify have all managed to establish their brands as global household names. However, investors would be hard-pressed to name a British tech giant on the same scale.

Until 2016, the UK’s biggest technology company was Cambridge-based ARM Holdings. Most smartphone and tablet users still have no idea that the the technology developed by this group of engineers powers more than 85% of all mobile devices (Richard Beddard, Money Observer, February 23, 2016). Unfortunately, Softbank’s acquisition of the company in 2016 took it off the London Stock Exchange, forever depriving retail investors of the chance to bet on the growing market for Internet-of-Things (IoT) devices and robotics.

The technology stocks that remain listed on the LSE are either so niche that most investors haven’t heard of them or so small that they stand little chance against their Chinese or American rivals. However, there are some companies that have the potential to dominate their niche. The fact that British technology remains overlooked and undervalued presents an opportunity for investors willing to take a closer look.

Accesso (AIM: ACSO) is a great example of this. Currently worth half a billion pounds, this AIM-listed stock is far from a global technology giant, but its software tools power the guest experience at some of the most recognizable tourists attractions in the world, including Alton Towers and Legoland (Steven Frazer, Shares Magazine, 19 Feb 2015).  

Other interesting tech stocks include gene therapy research firm Oxford Biomedica (LSE:OXB), ID verification services provider GB Group (LSE:GBG), and robotic process automation solutions provider Blue Prism (AIM:PRSM). Just Eat, the online platform that revolutionised takeaway food delivery, just entered the FTSE 100 for the first time last year. Valued at under £4 billion, JustEat (LSE:JE) is arguably Britain’s most well known tech success story (Josie Cox,Independant, 18 December 2017).

Meanwhile the UK is home to 22 out of a total of 50 European unicorns (startups worth over $1 billion) (Jonathan O’Callaghan, Alphr, 30 Apr 2018).  Many of these startups are focused on emerging technologies like biotech artificial intelligence (BenevolentAI), virtual simulations (Improbable), and online food ordering (Deliveroo).

Investors trying to bet on home-grown technology could either take a closer look at underrated tech stocks or wait for these exciting unicorns to open with investors in the near future.

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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Good governance is the unsung hero of investment returns

Management strategy, successful products, economic growth, and low interest rates are often the core drivers of investment returns. Sometimes, experts will go as far as to commend the corporate culture or CEO’s vision to explain the abnormal returns from a stock. However, investors tend to overlook the importance of good corporate governance.

Robust corporate governance is the antidote to an issue academics like to call ‘the agency problem’ (Sunit Shah, CFA Institute Research Foundation, 1 March, 2014). The agency problem is an inherent conflict of interest between those who run the company (management) and those who own it (shareholders).

The owner-manager relationship is fraught with misaligned incentives and asymmetric information. The responsibility of closing this gap and resolving the conflict lies with the shareholder-appointed board of directors. A healthy dose of oversight from an independent board could check the management’s tendencies to waste resources, cut corners, overpay themselves, or dilute the stock.

The board promises to uphold the rights of shareholders and safeguard their interests. It seems intuitive that stronger oversight and shareholder rights should lead to better performance. Indeed, recent studies have managed to establish this link.

A study of shareholder rights at 1500 large firms during the 1990s found that companies with a better score on the ‘Governance Index’ made fewer corporate acquisitions, had higher profits, lower capital expenditures, and better sales growth (Gompers et al., Quarterly Journal of Economics, February 2003). In other words, the value of the firm was noticeably enhanced by better governance.

Fortunately, measuring corporate governance at publicly-listed companies has become easier with the Institute of Director’s annual publication of the Good Governance Index (GGI). The GGI measures corporations based on 47 different governance indicators ranging from the percentage of CEO pay in stock to the frequency of board meetings every year.  In the latest report, Diageo Plc. came out on top with a score of 837. GlaxoSmithKline Plc. scored the least - 627 (IoD, Good Governance Report, 2017).

The GGI provides a window into the boardroom for retail investors. Leveraging these tools could help investors monitor their company managers more closely, mitigate the risks and moral hazards of owning a piece of a large company, and perhaps enhance their investment performance.

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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Measuring Dividend Quality

With fixed income yields at record lows across the developed world, income-seeking investors have had a tough decade. Ever since the financial crisis of 2008, the yield on government 10 year treasury bonds has tumbled from around 5% to 1.68% (investing.com). The hunt for income over the past decade has led investors to either buy-to-let properties or dividend stocks.

A number of FTSE 100 companies pay dividends many times greater than the income from fixed income securities. Most of these are household names. Vodafone, for example, pays out nearly 9% of its current stock price in dividends. Similarly, National Grid, Marks & Spencers, and the Royal Mail PLC offer dividend yields of 7.58%, 8.18%, and 9.51% respectively. The overall FTSE 100 pays just over 4% in dividends (David Brenchley, Morningstar, 23 April, 2018).

Such handsome dividends coupled with the opportunity for price appreciation make dividend stocks an ideal asset class for income seekers. However, investors need to take a closer look to ensure the dividends are sustainable. A sudden plunge in the stock price or an unexpected cut in the annual dividend payout could negatively impact the total return from these stocks.  

It is essential to establish a connection between a company’s dividends and its underlying economics. Companies need to have adequate annual earnings to cover their expected dividends. A dividend coverage ratio (net income divided by dividend) of greater than 1 is absolutely essential. Firms also need to have adequate cash, low debt, and healthy growth prospects to sustain the dividend long term.

Another important factor dividend investors must consider is the management’s philosophy. A number of cash-rich and stable businesses do not offer a dividend because the management believes it can generate a higher return for shareholders by reinvesting the free cash flow back into the enterprise. The most prominent example of this is Warren Buffett’s Berkshire Hathaway, which has never paid a dividend in its 54-year history (Aristofanis Papadatos, Seeking Alpha, Feb. 28, 2018). That’s despite the fact that the company’s cash hoard recently reached $116 billion. With this in mind, income-oriented investors need to pay close attention to a change in management or its dividend policy.

A well-diversified, high-yield dividend portfolio can help investors who rely on their investments for income. However, the cash flow from dividends is often unpredictable over a longer time horizon. Investors need to periodically check the financial health of the business to ensure their quarterly payments are sustainable.

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.

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.

Back