There are several reasons to invest in an income fund – to generate income, to be a ballast in a multi-asset fund or as a temporary warehouse for funds pending their investment elsewhere. But you always need to ensure your choice of fund manager is based on sound reasoning and not just because it’s a well-known name or due to past performance.
Income funds can be managed in different ways, from focusing on credit (corporate, parastatal or securitised debt) to increasing fund yields or managing terms and duration (interest rate risk) in anticipation of changes in monetary policy or other macroeconomic factors.
There is no right or wrong – it ultimately depends on your investment needs. For example, how do they fit best into your total investment solution? What are the levels and types of risk you are willing to take?
Here is a guide to help you make an informed decision:
1. Define your investment objectives
Spend time with your financial advisor considering such points as:
- Are you saving in a retirement annuity or drawing income from a living annuity?
- Are you investing temporarily pending investing elsewhere or is this a long-term investment?
- Is this a stand-alone investment or part of a larger solution?
- What level of income and liquidity is required?
- What is your appetite for credit and duration risk?
2. Look at the fund manager’s investment strategy
Examine a fund manager’s strategy and ensure it’s designed to generate consistent and sustainable income. Assess how the fund allocates between income-producing investments and verify that the manager maintains this strategy over time.
Popular investments include:
- Government debt such as listed nominal bonds, inflation-linked bonds or treasury bills.
- Fixed deposits and Negotiable Certificates of Deposit (NCDs) issued by banks.
- Subordinated bank debt.
- Corporate debt.
- Parastatal and municipal debt.
- Securitised debt (pools of loans, for example, mortgages, credit cards or vehicle financing).
The credit quality can vary considerably between these types of loans, and, in some cases, the return of capital becomes more important than the return on capital.
3. Review performance metrics
Look for income fund managers with sufficient experience and examine their track record across different market cycles. Look beyond recent performance for funds that consistently deliver on their promise over time.
In some cases, the return of capital becomes more important than the return on capital
Although income funds focus on capital preservation and risk management, they also provide attractive real returns over inflation. These returns can have the occasional negative month, although most aim not to have any negative quarters.
Examine the current and historical yield of the fund and compare this to the total return of the fund over time. Be aware if the performance is related to general market conditions or the manager’s abilities.
4. Evaluate risk management practices
“Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.” – Warren Buffet
Performance generally requires a trade-off with risk – to achieve higher performance one must usually take on greater risk which can be difficult to identify.
Consider the various types of debt issued by high-quality borrowers – such as the South African government and big banks – that may offer low-risk yields of around 10% pa. Now, if a manager is holding an underlying security, let’s say something like securitised motor vehicle loans, that is yielding 15% pa, then you need be realistic about the risk associated in getting you that yield.
Investigate the risk management techniques of the manager and look for strategies that include measures to protect against significant losses, such as diversification of credit exposure or hedging. Note that the standard deviation of past returns reveals nothing about credit risk. To the contrary, most high-yielding corporate and securitised debt instruments tend to show very little price volatility over time.
Safety first
At Matrix Fund Managers, we adopt a safety-first approach in assessing the different drivers of return and we favour those asset classes that will assist us in achieving our target performance with the least amount of risk. We focus on highly liquid securities with very low credit risk. We overlay thorough macro analysis and market research with proven in-house skills. Our robust processes have delivered compelling returns over time, in line with investor expectations on risk and volatility, without adopting unnecessary risk.
