Diversified will provide

There are many reasons for diversified income’s increase in popularity. For example, the low interest rates that have pertained since the record low of 0.5 per cent, meaning that the value of your money in a bank or building society account is shrinking in real terms. With wage growth stagnating while the costs of goods and services are rising, each pound is now buying less.

Many income portfolio managers now favour diversifying their selected investments when trying to provide a strong, reliable income stream for their clients. Diversified income portfolios typically invest in a spread of income-generating investments with the aim of reducing risk, including income risk and capital risk.

For income investors, understanding the potential volatility of their income is likely to be more important than loss of capital. Diversified income portfolios also offer investors the benefit of accessing different sources of income, including different asset classes and across global markets.

There are numerous different types of income. For example, multi-asset income funds will invest in shares, fixed income/bonds, property, cash and alternatives – that is, non-traditional investments such as commodities or private equity. Successful multi-asset income portfolios bring together different assets and underlying investment in single portfolio with the right income, risk and return characteristics.

Such traditional sources of long-term income as UK equities, corporate bonds and property still have a very important role to play in diversified income portfolios. But delivering a sustainable long-term income also means staying nimble in terms of accessing different types of income opportunity and active asset allocation.

Such traditional sources of long-term income still have a very important role to play in diversified income portfolios

For example, some recent alternative income ideas include re-insurance, energy infrastructure, secured property debt funds and asset-backed securities. These ideas are blended with many other investments, but play an important role in creating a balanced income portfolio.

Despite a number of large natural catastrophes in recent years, premiums increased, followed by a period of no claims, which was obviously good news. In this area, like all areas, an important part of the selection process is picking high-quality, disciplined managers.

Many infrastructure projects have a degree of government underwriting, either securing the project finance or supporting future profits. This sector can provide something like government-backed income, not too dissimilar to an index-linked bond. In this area, some of the best opportunities can come in closed-ended funds.

Secured property debt funds have been found with yields of 6 to 7 per cent and no duration risk, which play on the bank retrenchment theme. New investments in this space have generally been asset-backed in nature so you have a sense of credit security, and in more instances than not, they are floating rate.

One area of the asset-backed securities market providing opportunities for yield is mortgage-backed securities. Years ago, ABS investments were considered toxic, but interest in this sector has returned, and as long as you pick carefully, there are attractive yield opportunities to be found.

Diversification and active asset allocation are key ingredients for a buy-and-hold long-term income investor. But as with all investment choices, the key is a combination of getting the asset and investment choice right, and also picking the right manager for each investment.

Broadly speaking, there are two popular ways of getting income. One is encashing units or shares from an investment. The amount of income paid to the investor will depend on the number of units encashed and their price at the time this was done.

The level of income can potentially be managed, but the amount of shares that need to be encashed to achieve a desired level of income will depend on their price on the date of encashment. This income route guarantees that the number of units or shares will decrease over time, and is very exposed to sequence of return risk.

An alternative option would be to receive natural income from underlying income-generating assets. This is the income that the investor receives as dividends, which are aggregated from the dividends of the portfolio’s underlying dividend distributions. So the income in this case is the number of shares in a fund multiplied by the dividend per share.

The income can fluctuate over time but no shares have to be cashed in, so the income investor will have his full pack of shares to get paid dividends for as long as he holds the investment. The income share price will also fluctuate but should have the potential to grow over time. The decision is essentially a choice between obtaining natural income going straight through from the underlying holdings to investors, or by getting income by eroding capital.

A diversified portfolio of income-generating investments that aim to pay an attractive dividend per share over the long term, with no need to cash in shares to pay the income, is a popular choice for investors.

With so many people expected to retire over the coming years, diversified income portfolios, with all the potential benefits they offer, are likely to see a continued surge in popularity.

Mike Hammond is sales director of Premier Asset Management

Key Points

A strong income stream for investors, particularly those of a certain age, is vitally important.

Traditional sources of long-term income still have a very important role to play in diversified income portfolios.

An alternative option would be to receive natural income from underlying income-generating assets.