I was spring cleaning my study over the festive season when I came across a stack of notebooks that I had filed away over the years. Early on in my career I developed a habit of making handwritten notes about meetings and projects that I was working on. I stopped the spring cleaning for a bit and started paging through a few of the notebooks. It proved to be an interesting journey down my professional history as I came across notes about meetings with interesting people, and difficult periods in my career.
It was the notes from 2005 which got me thinking. I was marketing manager of a large unit trust company at the time, and was working on a new product development project. Our mandate was to launch a new fund around late 2005, early 2006. The debate had stalled with two products seemingly in deadlock; a real income fund and a stable fund. I was strongly advocating for the real income fund while others in the team were really keen on the stable fund.
Real income vs stable
A real income fund focuses on growing income over time, by a rate close to or better than that of inflation. The fund is expected to deliver a lower initial income than a typical income or enhanced income fund, but over the years it would grow this income by inflation, thereby ensuring that the client’s income maintains pace with inflation. Theoretically it should deliver more income over a long-term period than the other income funds.
A stable fund is a low-risk, multi-asset class fund that aims to deliver inflation beating returns over the short to medium term, at low levels of risk. The focus is on total return (income and capital return) and short- to medium-term capital protection.
My argument was simple: growth investors ultimately become income investors (at retirement). With retirees living longer the need for inflation protection on income was becoming increasingly important. There was a plethora of income funds and stable funds in the market, and I felt that we needed to launch a real income fund soon so we could build up a track record, and capture flows over time. Stable funds were becoming increasingly popular at the time and we needed to offer a more compelling product to compete for flows. The final decision was to launch the Real Income fund, but it was also decided that the Stable fund would be launched about a year later.
Have Real Income funds lived up to their mandate?
There are currently six Real Income funds in the market with total assets of approximately R5.3 billion. The largest fund is the Old Mutual Real Income fund, with R4.6 billion assets, while the oldest is Element Real Income fund which was launched in October 2002. The Element RI fund started out as the Fraters Real Income fund but the company changed names following the tragic death of founder James Frater in 2006.
To assess the track record of RI funds I have taken the longest possible period (the inception of Element RI) and compared income earned relative to income gorilla Coronation Strategic Income. The graph below shows income earned from a R1 million investment in each fund in October 2002.
There is evidence of income growth from the Element RI fund up until November 2008/09 but then income levels taper off. A cursory glance at the fund’s fact sheet finds that the objective of the fund is to grow capital and income over time, so there is not an exclusive focus on income growth. A look at the same analysis since the launch of the OM RI fund shows little evidence of income growth from either of the Real Income funds. The Clarus MET RI fund which was launched about seven years ago seems to be the only RI fund to have shown signs of delivering income growth since its inception.
So the evidence is not compelling with most of the funds seemingly focused on total return as opposed to income growth.
What is the challenge with delivering real income?
The main challenge facing fund managers is that income growth comes primarily from two volatile asset classes, equities and listed property. Inflation-linked bonds also grow income over time but initial yields have been low. Dividends from equities tend to grow at a rate higher than inflation, while rental income from listed property grows at a contracted rate stipulated in rental agreements.
However, these asset classes can be volatile from a capital perspective. Income investors tend to shy away from funds that show too much capital volatility, and so RI funds find themselves in that space where they are competing for a smaller pool of investor assets. Income investors, retirees in particular, would be put off by any short-term capital volatility and favour traditional income and enhanced income funds instead.
The graph below shows the income produced from a property fund and a dividend yielding equity fund relative to the same Coronation Strategic Income fund. There is clear evidence of income growth from the property and the dividend equity fund. Although they produced lower income initially, they delivered more total income over the period.
The reason the Coronation Strategic Income fund is significantly bigger than both funds is because of capital volatility shown in the graph below. Income investors do not seem to have the stomach for this capital volatility, and are often seduced by the initial higher income from the low-risk income fund. Therein lies the challenge for real income mandates, which is probably why managers tend to relent and focus on total return instead. There is over R360 billion invested in relatively conservative money market, income and enhanced income funds and less than 2% of that invested in real income funds, and asset management is a volume game.
Real income funds have a compelling proposition for income investors, but the asset management industry seems to have largely avoided the mandate. There is a real need for such a mandate but it does not seem that fund managers are prepared focus solely on income growth because of the capital volatility and the subsequent impact on sales. Managers that are prepared to tackle this challenge head on can, over time, build up track record which would allow them to compete for a larger share of assets. Until then they stand little chance of attracting any of the assets invested in enhanced income, income and money market funds.