Investors can be lulled into a false sense of security with income-generating investments.
Because they are seeking dividends from longer-term, lower-turnover stocks and funds, rather than aggressively seeking to cream the rewards of high-growth strategies, investors can become complacent that the dividend payments will always come in.
Unfortunately, this is not the case. Moreover, the way in which portfolios are composed can sometimes lead people astray in thinking their portfolio is well-balanced and the income streams are spread out, but in fact there is a high correlation or asset risk.
Moreover, some funds may be focused more on capital protection rather than on maintaining a sustainable dividend, while others may be focused on income generation regardless of capital erosion.
These risks may not always be immediately evident when first assessing a fund's suitability for a particular client.
Knowledge is power
For the end user, making sure the investment strategy is the right fit for the client's income needs is of paramount importance.
Patrick Norwood, insight analyst for Defaqto, comments: "It is vital for clients and advisers to know what type of income fund they are investing in."
Mr Norwood says: "Some funds will seek to preserve the capital value of the fund as much as possible, at the expense of income, while others will do the opposite, namely aim for a high income but with the likelihood that the capital will run down sooner. Many funds will be somewhere in between these two extremes."
While fund managers and investment advisers, however, will understand what the income/capital trade-off might be in an income-generating portfolio, communicating this to the client can be more difficult.
Indeed, trying to explain that volatility, while a risk to a portfolio, is not always a bad thing, can be difficult enough in and of itself. After all, there are so many things to consider, including:
- Political risk.
- Market risk.
- Credit risk.
- Currency risk.
- Interest rate risk.
- Sector-specific risks.
- Reputational risk.
Tim Morris, IFA for Russell & Co Financial Advisers, says: "Fund managers provide data on volatility – including standard deviation and the Sharpe Ratio.
"These are useful for advisers, yet mean little to the average client. Robust risk profiling is an integral part of finding the right strategy. This must be presented in a format which clients understand."
There are many agencies, such as Diminimis, Distribution Technology, Finametrica and others which provide some form of risk profiling tools, which can help advisers and their clients narrow down their attitude and financial tolerance for risk.
This can help the adviser narrow the range of appropriate and suitable investments for that particular client within the risk profile the client and adviser have selected together (or self-selected, if the client is provided with an online questionnaire before the initial meeting as part of the fact-find).