The questions to be asked of income funds

When considering which equity income strategy to back, advisers should focus less on the headline yield and more on how income is generated. 

Aiming to maximise or elevate dividend yield, or any other portfolio characteristic for that matter, has the potential to shift the composition of the underlying equity investment and the resulting income, total return and risk characteristics. 

Investors should be comfortable with the fundamental research and stock selection of the portfolio manager, given the dynamics of income investing. At first glance, a company with the flexibility to pay dividends typically maintains some capital discipline and has a sufficiently competitive position to generate positive cashflow.

But analysing company fundamentals also requires scenario and sensitivity analysis around cashflow generation and the ability to sustain dividends. 

A high dividend yield may be merely optical, because the market may have sold the shares in anticipation of a dividend cut. A highly indebted company may need to make higher interest payments should bond yields rise, which may reduce the cashflow available for dividends and may add interest rate sensitivity to the stock. 

 While the focus may be on generating income, advisers should still evaluate a new strategy in the context of a client’s overall investment portfolio

Investors may invest in a high-yielding stock as a bond proxy, and, as interest rates rise, the shares may be sold to increase the yield and maintain a specific premium over the risk-free rate. Finally, selecting a company for higher dividend yield may come at the expense of potential capital appreciation. 

Chasing higher yield could mean a portfolio becomes increasingly concentrated in certain sectors, regions, or bands of market capitalisation where higher yielding stocks could be present. 

This could create systematic risks that can have cycles of outperformance and underperformance. For example, overweighting energy names can establish an implicit correlation with oil prices, while overweighting European healthcare could increase the impact of regulatory reforms. Overweighting defensive names could leave the portfolio exposed to reflation trades and interest rate sensitivity, market rotations present in the second half of 2016. 

The level of dividends received may also be subject to the strength or weakness of the company’s operating currency relative to the investor’s. For example, a sterling investor having an overweight in eurozone names could see dividend translation gains if the euro strengthens against sterling. 

When constructing a portfolio, a manager often focuses on delivering a combination of income and capital appreciation. Do all stocks generate income, or are investors actually investing in two separate portfolios – an income portfolio and a capital appreciation portfolio – that are bolted together? Would you invest in the capital appreciation portfolio on a standalone basis? 

Beyond the underlying equity portfolio, some funds may try to boost distributions by investing in high-yield bonds, so investors should confirm the fund manager has the expertise to select such positions. In addition, some funds may employ derivative strategies to generate income. For example, a fund could sell call options, but perhaps at the expense of capital appreciation because these options would be based on portfolio holdings. 

Another question is what yield will investors ultimately see in their accounts? A headline yield may not match the actual distribution. Some countries, such as the US, may withhold taxes on dividends originating from that country. 

On top of this, a fund’s management fee may be taken from income, reducing the yield, or from capital, preserving the yield but reducing the potential for capital appreciation. 

In terms of asset allocation, how does the underlying equity strategy complement other investments in the client’s portfolio? While the focus may be on generating income, advisers should still evaluate a new strategy in the context of a client’s overall investment portfolio.

The benefits of equity income strategies are clear, but selecting an equity income strategy is not as simple as selecting the highest yielding fund. The challenge presents another opportunity for advisers to guide their clients’ investments to their client’s benefit. 

Stephen Tong is director and senior equity product specialist at HSBC Global Asset Management