EquitiesMar 12 2014

The merits of multi-assets

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It has been an incredibly challenging environment for income-seeking investors, who have seen interest rates on cash deposits remain stubbornly low and bond yields at or near record lows.

To compound matters, inflation looks set to remain around the Bank of England’s 2 per cent target rate, thus eroding an investor’s potential to generate a real return.

While fixed income and high-yielding stocks are popular sources of income, yield-seeking investors may wish to consider the merits of investing in a broader set of assets, particularly in the current economic and market environment.

The benefits of diversification within an investment portfolio have been well documented and they are just as powerful in the search for income as they are for capital growth. A multi-asset investment approach can successfully diversify and reduce the overall level of risk in an income portfolio, while also delivering a stable and sustainable level of income across the economic cycle. As income levels from different asset classes vary over time, a multi-asset approach allows investors to allocate away from those assets where the income is falling and towards those areas that are growing yield or offer capital preservation in market downturns.

It can also allow investors to gain access to the benefits of property, loans and infrastructure as alternative sources of income. Indeed, property-related assets and infrastructure show only modest correlations with equities and bonds, and contain an element of inflation-linking in their income. This can help reduce the risk of capital erosion as a result of increasing prices.

Substitute

An issue worth clarifying is whether property is a growth asset or a bond substitute. From an investment viewpoint, I classify assets based on the behaviour of their income and capital during the economic cycle. With this in mind, I consider property to be a growth asset because of its pro-cyclical capital behaviour and inflation-linked income. But it is important to recognise that the split of returns between income and capital varies depending on geography. Western European markets are much more bond-like in their behaviour, historically delivering around two-thirds of their returns from steady, relatively predictable income. So, in that respect, they are ideal for an investor looking for regular income.

In order to achieve a higher yield, all you need to do is look beyond the major cities to achieve high-quality income from high-quality buildings. In the UK, the property market tracked behaviour in the bond market up to 2009, at which point an unusual pricing dislocation opened up. Since then, unlike in bond markets, values outside the ‘AAA’ prime markets have actually been falling until recently – meaning yields have been rising. Non-prime yields had risen to such an extraordinary degree that, according to CBRE, the premium over 10-year gilts was a staggering 887bp in September 2013. There is a similar pattern in the core eurozone markets of Germany, France and Benelux, but the gap in the UK is the widest of any developed property market in Europe.

There are two main ways to access infrastructure assets. The first method is to invest through listed infrastructure companies in equity sectors such as utilities and energy. Alternatively, you can invest through listed securities representing private infrastructure vehicles. I prefer to invest in infrastructure through listed investment companies that are accessing the asset class through opportunities such as public private partnerships. This is a specialised asset class and we rely on the in-depth expertise of those third parties, which have a solid track record of investing in infrastructure.

Of course, detailed due diligence is important to identify the most appropriate investment vehicles. I have a preference for developed market infrastructure projects rather than those exposed to the emerging markets. I also favour infrastructure projects that are already operational – rather than in the planning stage – and those backed by government, with long-term contracts structured on payment by availability of the asset. I feel this reduces risk within this asset class and provides more certainty around the stability of the income stream over the longer term. Of course, no investment is without its risks. One of the key risks with infrastructure is political and regulatory – changes in government policies that negatively impact returns of future projects. This is one of the reasons why I prefer projects that are already operational.

Loans

One asset class that is often overlooked by those seeking income is loans – in particular, bank loans. Bank loans, also known as floating-rate secured loans or leveraged loans,

I favour infrastructure projects that are already operational – rather than in the planning stage – and those backed by government.

While loans have a similar risk/return profile to high-yield bonds, the asset class can be lowly correlated to high yield and therefore provides attractive diversification benefits. I prefer those structures that give exposure to high-quality loans within a well-diversified portfolio, with the underlying individual loans selected by an experienced team of experts.

Though the merits of investing in alternative assets for income are plain to see, they should not be treated as standalone replacements for income-yielding assets. Instead, they are more effective when combined in an overall income portfolio. It is also important to have a robust and detailed research process when selecting alternative income assets, making sure you fully understand the risks you are taking when investing in these asset classes.

However, overall, a flexible multi-asset approach seeking opportunities across asset classes and geographies can significantly improve the chances of achieving your client’s desired income.

Eugene Philalithis is portfolio manager of Fidelity Solutions

Key points

■ It has been difficult for investors to get income in the current low-interest rate environment.

■ Using a multi-asset approach is one way to build up a client’s income. .

■ There are a variety of different assets that can be accessed through a multi-asset fund.