The types of investor in each of these categories are likely to be as follows:
Low Income Volatility - The client has a greater need for a consistent level of income from their investment and a need to safeguard their initial investment against market downfalls. The client will have a low capacity for loss and may require investment income for non-discretionary spending.
Medium Income Volatility - The client will be able to accept a short-term fall in their investment, with the expectation that this risk would be rewarded with greater income and capital gains in the long-term. The client has a need for level or growing income over the long-term but will accept short-term fluctuations.
High Income Volatility - The client will be able to tolerate falls in investment with the expectation that this risk is rewarded with level or rising incomes in the long-term. The client will have higher capacity for loss and is likely to require investment income for non-discretionary spending.
Capital Preservation - The client has a need to safeguard their initial investment and has a low capacity for loss. They have a high income risk tolerance and would be willing to tolerate fluctuating dividend payments. They are likely to use income for discretionary spending purposes only.
As with all investments there will be a trade-off between return and risk.
Defaqto's process for deciding which of the above four categories an income fund should fall into relies on the principle alluded to above that the total return for any fund can be broken down into the income part of the return and the capital gain or loss, and that these income and capital gain/loss components, as well as the total return, will each have an associated volatility or risk.
Therefore, there is a trade-off between income and capital as well as return and risk.
Defaqto's methodology for deciding which of the four income risk ratings an income fund should receive is based on:
- The fund’s historic capital and income volatilities
- The maximum capital drawdown that the fund has seen
- The consistency of the fund’s annual income payments
- The fund’s asset allocation
- The name and mandate of the fund
- Discussion(s) with the fund manager.
This analysis will be reviewed every year for each fund that Defaqto rates with the latest numbers and information to ensure that the rating given to the fund is still accurate on an ongoing basis. If it is no longer accurate, Defaqto would look to change the rating.
As well as rating income funds from a suitability point of view, Defaqto also produces ‘Diamond Ratings’ based on the perceived quality of the income fund.
So that Defaqto is comparing like for like when producing its ratings, it has divided income funds into the following categories of equity income funds, bond income funds and multi-asset income funds.