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Asset Allocator

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How DFMs are meeting income needs; Wealth managers' classification conundrum

Welcome to Asset Allocator, FT Specialist's newsletter for wealth managers, fund selectors and DFMs. We know you're bombarded with information, so each day we'll be sifting through the mass to bring you what you need to know, backed up by exclusive data and research. 

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Yielding to demand: DFMs' income plays

It's become a familiar quandary for DFMs: the low-yield environment means that generating a decent, sustainable income is no mean feat. Yet demand for these strategies has never been higher.

Discretionaries have adopted a variety of approaches to this problem. Nowadays, most wealth firms run at least one model portfolio with an explicit income focus. But these models' yields can differ notably - even when stated levels of risk are the same.

That's evident from our analysis of 20 income models, each with a Distribution Technology risk rating of 5. The chart below shows that, even on the basic metric of stated yield, the dispersion is significant.

The average yield comes to around 3.3 per cent, but it's the spread of outcomes that's most evident. The highest yield, of nearly 5 per cent, is miles apart from the 1.8 per cent on the other side of the chart.

How does that compare with rival investment offerings? A recent look at some of the top multi-asset income funds indicated an average yield of 3.7 per cent.

Many Income model portfolio managers would consider themselves less risky, and able to provide greater diversification, than such funds.

But there are commonalities to be found. Despite the growing range of alternative income funds, both DFMs and their rivals still rely heavily on equities to generate yield. 

The average IA UK Equity Income fund pays a 4.4 per cent yield. When funds that write call options are included, this rises to 4.6 per cent.

That means that those seeking higher incomes will inevitably have to head further up the risk curve.

Take the DFMs that run a series of income portfolios, running from risk bands 1 to 10. While lower risk offerings have a more balanced blend of asset classes, equity income exposure typically accounts for more than 80 per cent of those at the other end of the scale. Equity risk is still as central to income strategies as it is to conventional growth options.

What's in a label? Classing convertible bond funds

It’s not uncommon for managers to view an investment differently. One investor’s bargain is another’s value trap. And reaching agreement is even trickier when the holding in question can morph into something else.

Such is the conundrum for convertible bonds. With no obvious consensus as to the right way to classify them, DFMs can make their own minds up. They can, at least, if they're not running unitised portfolios. Several wealth managers spoke out last year about Investment Association sector rules which effectively oblige them to count convertibles as equity exposure.

Our own MPS tracker shows the topic is still splitting opinion. There are nine different convertible bond funds currently held across the discretionary models we track: eight active funds, the most popular of which is RWC's offering, and (inevitably) one ETF. These funds are classified as bonds, alternatives, equities or 'conservative equities' depending on where you look.

Contrary to the IA's requirement, our figures show the most popular way to categorise convertibles is via the path of least resistance: convertible bonds are bonds. As Neil Shillito said last year, the ability for said bonds to be converted to equity is a right, not an obligation.

The conclusion has to be that the trade association should take a lesson from the asset class itself and be a bit more flexible in its approach.

Correlation crunch time

We've talked before about the areas where perceived asset correlations appear to be growing (or shrinking). But there's one area where many investment managers like to rely on the link being weak: the behaviour of markets versus underlying economies.

It's an argument that, over recent years, has been used many times to dismiss worries about frothy equity valuations and even volatility, particularly in the US. If the economy is performing well, there is little reason to believe markets will not continue to trend upward.

So perhaps there's reason to stay optimistic after recent market volatility. But as this column, published in the FT, notes, there are still reasons to be concerned. For one, markets and the economy are currently facing the same challenge, in the form of tighter monetary policy.

As the column points out, the connection between bear markets and recessions does vary between different regions. The link remains weak in places like Europe and the UK - though these markets are easily influenced by happenings on Wall Street.

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