Why equities matter more for income investors now

He says that in a world where inflation may linger at a higher level in the next decade than has been the case for the past decade, the only answer is for clients to have more exposure to equities.

He says: “The asset that looks best suited to protecting investors from persistently higher inflation is equities, particularly the companies that are growing structurally. Government bonds still don’t offer positive real yields, but they can be useful in portfolios as a diversifier for when equities are volatile.”

Structurally growing equities would tend to be those that are less cyclical than the more value-type equities that are often held in income portfolios. 

Many of those stocks do perform well in a rising interest rate environment, but also are vulnerable if economic growth slows, whereas structural growth companies should be able to grow regardless of wider economic conditions. 

A large fall in equity markets early in an investor’s retirement can meaningfully affect his or her long-term wealth.Fahad Hassan, Albermarle Street Partners

Coombs says that with investors likely to spend a longer period in retirement than has been the case in the past, there is a greater need to own more of those growth equities than has been the case historically, alongside the more obvious income stocks.

Alex Funk, chief investment officer at Schroders Investment Solutions, says the sort of structural growth stocks that might be a hedge against inflation tend to be found in the US, while the more traditional income stocks are in the UK and European equity markets. 

He says an investor’s view on inflation therefore has a significant impact on the proportion of the equity allocation placed into each part of the market.

Funk says the changes investors need to make right now are within asset classes, as while bonds do not look attractive now, he continues to believe they have a long-term future in portfolios and at points over the next decade will look attractive.

Volatility 

Fahad Hassan, chief investment officer at Albemarle Street Partners, says he is sceptical that the changing global landscape ultimately alters the picture in terms of allocation to equities for a client in or near retirement. 

He says the volatility of equities means it is always a challenge to increase the level of equity exposure in portfolios, as extreme market movements, even if short-term in nature, are not helpful for clients in retirement.

We do not think you can make generalised comments about the sectors and stocks that are likely to do relatively well in the foreseeable future.Simon Murphy, Tyndall

Hassan says: “Multi-asset income portfolios generally contain corporate and government debt and a variety of equity exposures. Broad equity indices however have high levels of correlation and are twice as volatile as government bonds over the long term. During market sell-offs equity indices can fall by 50 per cent.

"While markets may eventually recover, investors withdrawing income may never regain lost wealth. A large fall in equity markets early in an investor’s retirement can meaningfully affect his or her long-term wealth.

"Equities represent the largest risk of portfolio drawdowns and are therefore the source of the greatest risk to the long-term wealth of income investors.”

Sue Noffke, a long-serving UK equity income fund manager at Schroders, takes the view that the end of quantitative easing has distorted asset markets, including equity markets, and it could, as a result, be a turbulent time in equity markets. However the same dynamics would also apply to fixed income assets.

Future prospects

Simon Murphy, who runs the Real Income fund at Tyndall, says: “We believe we are in a period where we will see higher inflation than we have been used to over the past 20 years or more.

"We do not expect to stay at the current very elevated levels for long, but more likely settle back towards a 3 per cent to 4 per cent type level, which will still feel very different to the 1 per cent to 2 per cent environment of our recent past."

Murphy adds: "While interest rates will rise further in the near term, it is likely that they remain below the level of inflation for some time to come and so ‘financial repression’ is definitely something to be very mindful of. 

While equities are more volatile, the time horizon is also longer in retirement.Darius McDermott, VT Chelsea

"It has been such a long time since we have operated in a sustained inflationary environment, and corporate dynamics, use of technology etc have changed so much in the intervening period that we do not think you can make generalised comments about the sectors and stocks that are likely to do relatively well in the foreseeable future."

Coombs says the problem faced by investors is that many of the stocks that offer the highest yield are also often stocks that “have no growth, and so one is basically turning capital into income, and that’s fine in a world of lower inflation, but not when inflation rises and persists. Also, given longer lifespans, investors may need to have more growth in portfolios”.

Darius McDermott, who advises the VT Chelsea range of multi-manager funds, says that “in simple terms, if people are going to live longer then they need more growth in portfolios, and equities are there to provide growth. Fixed income is not traditionally owned as a growth asset, while equities are.

"While equities are more volatile, the time horizon is also longer in retirement."

david.thorpe@ft.com