Using alternative income streams within a portfolio

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Rathbones
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Supported by
Rathbones
Using alternative income streams within a portfolio

At the same time, the yield on offer from traditional income assets is as low as it has ever been.

This is largely down to the role central banks have played and it is an environment that has left income managers chasing alternative sources.

Andrew Morgan, portfolio manager of Alpha:r2 at Walker Crips, explains the “increasingly desperate” hunt for income can be traced back to the distortion in markets triggered by quantitative easing (QE), resulting in boosting asset prices and compressing yields.

“As a result, many investors see regular equities and bond markets as overvalued, and are disappointed by their income levels. 

“Investors also worry about what will happen as QE unwinds: with interest rates close to zero, bond capital values are likely to be hit as rates normalise,” he predicts.

Since the global financial crisis, asset prices have risen and accompanying yields, not necessarily absolute payouts, have fallen.Andrew Herberts

Andrew Herberts, head of private client investment management at Thomas Miller Investment, says: “As central banks have kept interest rates low, investors have been forced to look beyond traditional assets to maintain income at historic levels. 

“We can argue whether searching out income per se is an efficient investment strategy, but the fact remains that a significant proportion of investors are focused on income. 

“Since the global financial crisis, asset prices have risen and accompanying yields, not necessarily absolute payouts, have fallen.”

Many fund managers are being forced to look beyond the traditional asset classes to meet income requirements, and other targets, in their portfolios.

One of these is Matthew Yeates, investment manager at Seven Investment Management, says this includes investing in assets such as gold, infrastructure and option strategies.

He confirms: “We are looking more broadly because we don't have the same confidence bonds will continue to play the role they used to in portfolios while yields remain so low. 

“This is from the perspective of income, but that's only half of it – if inflation fears continue and the risks of a taper tantrum rise (where equities and bonds fall at the same time over fears of rising rates) they are unlikely to provide the diversification to equities regardless of the currently small income they provide.”

Alternative risks

Anthony Rayner, co-manager of the Miton Cautious Monthly Income fund, acknowledges the increasing popularity of alternatives in a world of low income and high correlations between asset classes.

But he also warns of three possible risks:

  • Equity beta risk.
  • Interest rate risk.
  • Credit risk.

He insists: “Alternatives are simply made up of these risks under a different label, and therefore shouldn’t be expected to provide material diversification.”

But surely being in risk assets will help beat inflation, which has settled at around 3 per cent in the UK?

One way for managers and investors to access alternatives is via an investment trust.

Peter Elston, chief investment officer at Seneca Investment Managers, explains the advantages of using investment trusts to allocate to alternative assets.

“Income streams tend to be inflation linked, either explicitly as in the case of infrastructure – price tariffs that are based on RPI – or implicitly as in property – rental income streams tend to be linked to broader inflation,” he reasons. 

“Furthermore, the share prices of the trusts themselves on the whole exhibit low volatility and low correlation in relation to broader equity markets. The combination of these market attributes, as well as the higher, index linked income streams, means that adding them to a portfolio can both enhance return and lower volatility.”

Not the answer

But for some managers, alternatives are not the answer – simply diversifying away from bonds and equities does not necessarily guarantee any more income.

Will McIntosh-Whyte and David Coombs, who manage the Rathbone Multi-Asset Portfolio Funds, issue a note of caution about alternative income, that if something seems too good to be true, it probably is.

“We always remind ourselves that return is linked to risk,” explains Mr McIntosh-Whyte. 

“If something offers a significantly higher yield, it tends to be because of the higher risks involved. 

“One area that we have found income at a reasonable price is in structured products. These are contracts with investment banks offering cash payments that are dependent on certain market conditions or events – for example, the S&P 500 doesn’t fall more than 50 per cent.”

Advisers are becoming increasingly familiar with the benefits that access to listed infrastructure can bring to client portfolios and predict that the asset class will continue to grow over the coming years.Jamie Richard

Another strategy the managers use in their portfolios is to make the most of market dislocations to lock in yield.

But he admits: “These are higher risk strategies than the traditional sources of portfolio income. 

“To ensure our cash flow is solid, we buy short-dated, high-coupon government and investment grade bonds. These give our portfolio a high ‘natural’ cash flow in return for a small capital loss at redemption. This capital erosion is offset by the superior capital growth we target from our equity investments.”

Infrastructure boom or bust?

Andrew Morgan, portfolio manager of Alpha:r2 at Walker Crips, says alternative investments can potentially meet some of the perennial need for income, “particularly infrastructure funds where the underlying investments tend to have good visibility of earnings and therefore relatively stable cashflow and income payments”.

Infrastructure has been in the headlines for all the wrong reasons lately though, following the collapse of the contractor Carillion, leaving many infrastructure projects unfinished.

The Share Centre’s investment manager Sheridan Adams, reported this was reflected in the top five most sold funds in January this year.

“It’s not surprising that funds associated with the infrastructure sector feature heavily in the top sold list. The collapsed government contractor Carillion, who failed to find a rescue package and subsequently fell into liquidation grabbed headlines in January,” he confirms. 

“The news was dominated by the story, putting a renewed focus on the support service sector and questions were then asked about how these companies operate.”

Recent research by Foresight Group, conducted among 73 financial advisers in the UK, finds 69 per cent of intermediaries are concerned about the risks of what it calls “fake infrastructure”, although the survey also reveals that advisers predict allocations to infrastructure will reach 7 per cent in the next five years.

Jamie Richard, partner at Foresight Group, explains: “Advisers are becoming increasingly familiar with the benefits that access to listed infrastructure can bring to client portfolios and predict that the asset class will continue to grow over the coming years. 

“What’s emerged from the collapse of Carillion is a much clearer understanding of listed infrastructure and listed ‘quasi’ infrastructure, comprising products that have been incorrectly badged.” 

He adds: “We expect this will encourage a flight to quality as advisers recommend opportunities that provide access to the consistent, inflation-linked underlying cash flows that make the asset class so attractive, particularly in times of uncertainty when markets are rocked by volatility.”

eleanor.duncan@ft.com