When you establish your investment portfolio, your financial adviser, or investment manager will ask you to identify the investing strategy you plan on utilizing to manage your money. Most of the time, they'll do it on a risk profile questionnaire, having you select from a pre-existing checklist that might include things like, "capital preservation", "growth", "speculation", and "income". These are commonly known as an investment mandate profiles. Unfortunately, seldom does the profile match the expected results!!
In this series of articles we want to discuss income investing and the options available.
What is an income investing strategy? How does it work? What are its benefits and shortcomings? Why would someone choose it over the alternatives? Great questions, all. Let's delve into them so you emerge with a better understanding of the types of investments that might be held in an income strategy portfolio, as well as the opportunity cost you'll incur by not opting for one of the other common approaches.
1. What Is an Income Investing Strategy?
The phrase "income investing strategy" refers to putting together a portfolio of assets specifically tailored to maximize the annual passive income generated by the holdings. To a lesser degree, maintaining purchase power after inflation adjustments is important. A tertiary concern is growth so the actual real dividends, interest, and rents are increasing faster than the inflation rate.
2. What Is the Objective of the Income Investing Strategy?
The reason investors put together an income portfolio is to produce a constant stream of cash that can be spent today, generated from a collection of higher-than-average yielding assets; cash that can be used to pay bills, buy groceries, purchase medicine, cover tuition for family member, or any other purpose.
3. What are the traditional types of Investments Used to Construct an Income Strategy Portfolio?
The specific asset allocation among the different asset classes will vary with the size of the portfolio, interest rates available at the time the portfolio is constructed, and a host of other factors but, generally speaking, an income strategy will require some mixture of:
- Money market accounts and structured deposits- a money market fund is a type of insured product offered by a bank while a structured deposit is a specially structured instrument that invests in certain types of assets and which the share price is tethered to EUR 1.00. When interest rates are ample relative to inflation, a structured deposit can be a magnificent way to park surplus funds. Income distributions can range from 2% to 7% on your money, subject to the types of assets that are linked to the instrument.
- Bonds and other fixed income securities including government bonds, corporate bonds, and municipal bonds as may be appropriate based on the credit rating risk characteristics of the portfolio. Typical return between 2%- 5% in EUR, subject to risk profile.
- Stocks, dividend-paying blue chip stocks with conservative balance sheets that have a long history of maintaining or increasing the dividend per share even during horrible economic recessions and stock market crashes . Typical return between 2%- 6% in EUR, subject to risk profile.
- Real estate including both outright ownership of property (perhaps through a limited liability company) or through real estate investment trusts, known as REITs. The latter have significantly different risk profiles and the investor can be diluted out of his or her equity if the management team isn’t conservative enough but a well-purchased REIT can result in substantial wealth creation. For example, during the last market collapse in 2008-2009, some REITs lost 60% to 70%, of their market value as rental dividends were cut. That said, Investors who bought these securities as the world was falling apart have already, in some cases, extracted their entire purchase price in aggregate cash dividends. Typical return between 4%- 7% in EUR, subject to risk profile
4. What are the alternative types of Investments Used to Construct an Income Strategy Portfolio?
In a low interest rate environment, some fixed income investments struggle to generate meaningful income for investors. Investors often feel they only have two options; reach for higher-yielding, but riskier investments; or settle for low, or even negative real interest rates from traditional, lower risk fixed income.
Examples of alternative income investments include factoring and asset based lending, both of which have the potential to offer higher rates of interest relative to traditional income investments.
These kinds of investments generally show low correlation to other asset classes, making them great portfolio diversifiers, and may provide protection when interest rates rise (an inflationary environment), as the underlying income generated is normally linked to prevailing interest rates.
These types of investments have long played a part in institutional asset allocation strategies (also known as “the smart money”), and can be accessed by individuals through innovative funds employing alternative strategies. When managed by experienced investment professionals, these strategies have the potential to reduce the overall risk of an investment portfolio and add much-needed income.Let’s look at alternative income investments a little more closely
Asset Based Lending
Asset – based lending is lending secured by an asset. Asset – based lending funds provide retail investors with access to private loans, which are difficult to source and manage on a direct basis. One strategy that is used is that the fund identifies short term opportunities with mid-sized companies that are otherwise unable to access financing. Often due to their size, perceived risk, complexity of their business and timing or simply banks are not willing to lend.Rigorous risk assessment and due diligence process are at the core of this strategy. All loans are senior secured and collateralized, the portfolio is diversified to further reduce risk. The interest rate charged by the lending fund to the borrower represents income to the fund. The rates are typically higher than prevailing bank interest rates because of the nature of the loan and/or timing but they are still tied to the base rate, therefore can generate income in all rate environments. Typical return between 5%- 9% in EUR, subject to risk profile
Factoring Based Investments
Factoring is the sale of a company’s accounts receivables to a third party. These accounts receivables are sold at a discount, in exchange for immediate cash. Many fast growing, quality companies that may not meet banks’ very stringent borrowing requirements, use factoring to meet their immediate cash needs. By selling their accounts receivables to obtain cash, capital is made available for investment in the company’s growth.As an example a manufacturer sells its products to a large well-known national retailer. The retailer pays it’s bills every 60 to 90 days, but the manufacturer needs the money sooner to grow the business and pay its employees. This creates a factoring opportunity, where a factoring investment fund buys the receivables from the manufacturer at a discount and holds them until the retailer pays the full amount of the invoice. The difference between the cost of the receivable and the payment value represents income to the fund. The interest rate, or the charge, applied to the receivable is usually linked to the base rate, so the investment can provide income in all interest rate environments. Typical return between 5% -9% in EUR, subject to risk profile.
Royalty unit trusts.
These are publicly traded trust funds (different from basic unit/investment trusts) that, in many cases, are not authorized to grow but instead hold a collection of assets that must be managed and the proceeds distributed by the trustee, often a bank. These trusts tend to hold the right to royalties on oil and natural gas wells, making them extremely volatile. Furthermore, they have finite lives. There will come a point at which they will expire and disappear so you must make absolutely certain you are paying a rational price relative to the proven reserves at a conservative estimation of the value likely to received for the commodity when it’s sold. This is an area where it is best not to tread unless you are an expert because you are most likely going to lose money. Still, they can be wonderful tools under the right circumstances, at the right price, for somebody who has a deep understanding of the energy, mineral, or commodity markets. Typical return between 6% -10% in EUR, subject to risk profile.
Investors face a number of challenges and trade-offs in this market when constructing a portfolio to meet their long-term goals. Many are looking for income, but are struggling to find it in this low-yield environment, and they worry about the impact that rising interest rates may have on their fixed-income portfolios. Many investors are turning to dividend stocks to meet their income needs, but there are other options.
By adding any of the alternative investment strategies to your income strategy you have the potential to add portfolio diversification and a distinctive, alternative source of yield to your portfolio. In summary, these alternative income strategies have low correlation to traditional income asset classes but can provide an excellent complement to traditional income allocations.
Investors concerned about rising rates and sources of investment income should consult with their financial advisors to develop an effective long-term strategy for their portfolios. In some cases, that may mean expanding a portfolio to include both traditional income and alternative income opportunities. Others may simply need to refine an existing strategy in one or both asset classes.
All investments involve risks, including the loss of principal invested. Investors should consider individual circumstances, risk tolerance, and investment goals when making investment decisions. Hopefully, this article will help you start the discussion with your advisor.
The author of this article is Marcus Queree, Partner & Director of DNA Wealth. Any information herein is only expressions and opinions. This document does not constitute an offer, an invitation to offer, or a recommendation to enter into any transaction, nor does it constitute investment advice. The information contained herein is confidential and reproduction of any part of this material is prohibited. If you are in any doubt as to the suitability of an investment you should always consult your financial adviser. DNA does not receive any form of compensation for circulation of such material.