The two-horse race to reliable returns

FS Tomas Hirst byline 160

With persistent above-target inflation and falling real wages the Great Recession has challenged classical economic theory. It has also posed serious difficulties for investors looking to preserve their capital without taking on excessive downside risk.

Since the onset of the crisis a sluggish economy and volatile markets have combined to cast a long shadow over investment portfolios. Yet despite the headwinds there have been opportunities but it has taken strong stomachs.

Over the past three years the top performing IMA sector has been North America Smaller Companies, with the average fund returning 50.49 per cent in sterling terms. Meanwhile faster growing emerging economies have struggled to keep pace leaving the IMA Global Emerging Markets sector in the bottom half of the performance table returning an average of 17.93 per cent.

Cautious investors worried about the outlook are unlikely to have been tempted to put too large a portion of their portfolio into higher risk smaller companies funds. Indeed the search for stable, above-inflation income has become a dominant theme in the marketplace over recent years.

Unfortunately with central bank purchases of developed market government debt and the consequent surge of interest in investment grade debt as a substitute, yields of so-called “safe haven” assets have been pushed downwards. This has left a limited spectrum of assets that meet the income payouts that investors require to achieve a real return on their capital.

Of those that remain equity income and high yield debt have provided some interest. Indeed these asset classes appear to have shared a similar performance trajectory with each other over the past three years.

However, headline figures may well be deceiving as they differ significantly in the investment profile they offer.

“High yield bonds are more akin to equity-type risk than investment grade, so I can understand why people would compare them,” says Graham Toone, the head of research at AFH Independent Financial Services and Adviser Fund Index (AFI) panelist. “You would expect a bit more day-to-day volatility on the equity side, however, and with high yield debt there is always default risk to consider.”

One of the major differences between mainstream equity income products and high yield bond funds is the underlying companies in which they invest. Traditionally companies that have a long track record of dividend payments are larger, blue chip players whereas by definition companies issuing higher yielding bonds tend to be higher risk propositions.

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As Toone suggests, if the economic environment worsens some of these higher risk companies could be in danger of defaulting on their debt leaving investors nursing their losses. Moreover larger companies with strong balance sheets and sustainable earnings streams offer the potential to increase their dividend payouts.

“There are some equities that offer decent yields still out there. Fixed income coupons are, by definition, fixed but with equities you would expect some dividend growth,” says Graham Ashby, senior portfolio manager at Ignis Asset Management. “Corporate balance sheets for the most part are the strongest they have been for a decade and dividend cover remains good.”

There is also liquidity risk to consider. Unlike equities, high-yield debt is more difficult to trade in and out of, as trading volumes in the securities are much thinner. This means that once a position is established it can be very difficult to move out of if market sentiment turns.

Toone, however, suggests that the recent surge in interest towards the asset class has caused its own problems.

“We have become a bit concerned over the amount of money going into high yield at the moment. It’s becoming less clear whether there is sufficient value for the risk you’re taking,” he says.

While these potential pitfalls may be growing, on the other side of the debate is concentration risk of equity income portfolios. A now familiar statistic is that the five biggest players accounted for 36 per cent of UK dividend payments in the first half of the year. These include familiar names such as Cairn Energy, GlaxoSmithKline, HSBC, Royal Dutch Shell and Vodafone.

If one of these were to suffer a sharp reversal in fortunes then income funds would see a disproportionately large impact on performance relative to other UK equity products. Royal Dutch Shell, for example, has seen earnings fall on the back of lower oil and gas prices in the last quarter although it did raise its quarterly dividend by 2.4 per cent from the previous year.

Yet there is a second concentration risk to be considered. The top 10 funds in the IMA UK Equity Income sector account for some 70 per cent of total assets under management. Of this Neil Woodford’s Invesco Perpetual Income and High Income funds account for 38 per cent of the total.

Of course, there will be times when scale is a benefit but it is also clear that trading becomes a significantly more complex process with huge volumes. Picking a fund that both offers a compelling track record of performance and the security that investors are searching for may be a challenge. This will be particularly true if the UK follows the US’ example and corporate earnings disappoint.

So in terms of the equity income versus high yield debate, there are still a number of reasons to consider both as long as the risks are understood. Nevertheless, at least some of the recent performance in these asset classes reflects a broader yield grab by investors rather than improvements in fundamentals. That fact alone should give investors pause.

Yet though easy gains may now be scarce, the search for yield does not look to be over yet.

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