What really makes a diversified income fund run?

It's time to take a proper look under the bonnet and find out what makes a diversified income fund run. Who else better to ask than Mint’s diversified income fund mechanic (ok Portfolio Manager) Marek Krzeczkowski to explain the components that impact the running, and ultimately the performance of these types of funds.

Tuesday, October 1st 2019, 7:00AM

by Mint Asset Management

Marek Krzeczkowski

So Marek before we get our hands dirty, tell us a bit about your background?

“I come from Poland and was born in Gdansk which is a port city on the Baltic coast. I spent my early career (12 years) in sunny Scotland working for BlackRock, Baillie Gifford and TCAM Asset Management. In my last role, I managed a research team and was responsible for the asset allocation and stock selection for over $2 billion funds that we managed. I don’t have much time for many other interests outside family, and work, but I do enjoy a spot of fishing with the kids.”

When thinking about diversified income funds what are the key deliverables and elements that contribute to their overall performance?

“The two main deliverables you would expect from a fund like this is the ability to provide income and capital preservation. This means ensuring that the buying power of that capital is maintained while assisting investors' income needs. Most income funds will invest in all of the major asset classes and have a strategic asset allocation (SAA) which is developed to take into account the maximum weights needed for each asset class in a complete market cycle. An active fund manager like ourselves will also apply a tactical asset allocation (TAA) to take advantage of market fluctuations and use derivatives to manage risk. Every fund will have an investment objective so the investor knows what to expect by way of outcome. For example, ours is the consumer price index (CPI) plus 3%.”

Thinking about where income funds sit between risk and return, what would be the minimum time horizon investors should be expecting to invest their money for?

“Let’s be clear income funds are not a proxy for term deposits. Much will depend on the allocation of growth assets, but as a minimum these funds would generally sit in the medium to long-term bucket. The key here is when advisers are talking to their clients they need to stress that their capital may fluctuate given the exposure (no matter how small) to growth assets. However, over the medium to long term, they will be rewarded for taking on a little bit more risk.”

So how is the income derived?

“Every managers proposition in this space is a little different, by way of example Mint uses bonds and property to generate income, equities to grow the capital and derivatives to manage risk. Income is paid quarterly and you can choose to have it paid out or reinvest it into the fund. Essentially each quarter we sweep out all the income generated and pay it to those investors who seek a regular income.”

What would happen if some time in the future we entered a perfect storm where interest rates start going up and equities go down, how would a fund like this react, and as a portfolio manager what would you do to protect the investor?

“Again, this will depend on the fund and asset allocation. The more growth assets the strategy has, the higher the return potential, but also the higher the risk of a larger drop in value. Asset allocation and portfolio construction play a very important part. Firstly, diversification – making sure that the portfolio has a mix of assets that have a low correlation. Secondly, risk – understanding portfolio exposures and managing risk by positioning the portfolio according to the macroeconomic environment. By way of example, we use TAA to assist with this. We review portfolio positioning monthly (as a minimum) and adjust asset allocation depending on what we expect on tactical (one to three months) and strategic (12 months) time horizons. This can include reducing or increasing growth assets, cash balance, managing duration of the portfolio (exposure to interest rate changes) or hedging risk using derivatives.”

Talking to advisers they are getting new clients that are looking for income due to falling bank deposit rates. Should investors and advisers for that matter, accept that we are going to be in a low-interest-rate environment for longer and may have to take a little more risk to keep their buying power of savings ahead of inflation?

“Some exposure to growth assets may be required to generate returns above cash, and that means taking on a little bit more risk. Having said that investors shouldn’t jump into a lot more equities especially if it’s not appropriate based on their personal financial circumstances.

Term deposits are currently paying around 2.7% gross, so after tax (assuming 33%) the net return is 1.79%. If you take long-run inflation of 2% then you are not maintaining the purchasing power of your capital, let alone growing it. If you compare that to our income fund, where the return target for this fund is CPI + 3%, that currently gets you (assuming latest CPI of 1.7%) to a return of around 2.76% after tax and after all fees including GST. That 2.76% is around 54% higher than the return from the term deposit. The difference is that the income fund has exposure to growth assets, but there are no guarantees that during any given market cycle it will always deliver a positive return.

Look, it’s hard to see rates moving up at the moment with central banks around the world easing monetary policy and cutting rates as a consequence. The RBNZ left rates unchanged in August, but markets are currently pricing in a high probability of rate cuts in Australia and the US next month – having that in mind, I would expect the RBNZ to cut rates further over the coming months. That will most likely reduce rates on term deposits further which will drive more investors searching for yield.

The thing I worry about the most is investors may see higher returns being advertised but not understand the risk involved. Income funds in association with good quality advice may be a suitable investment solution for investors especially given we all seem to be living longer these days.”

Mint Asset Management is an independent investment management business based in Auckland, New Zealand. Mint Asset Management is the issuer of the Mint Asset Management Funds. Download a copy of the product disclosure statement at mintasset.co.nz

Tags: diversified income funds Diversified Investment Strategies interest rates investment Mint Asset Management Opinion RBNZ