Offering upside exposure with downside protection
• Flexible fixed income unit trusts suit those seeking to maximise real returns, writes Alf James
Over the past decade, there has been significant innovation in the types of flexible fixed interest unit trusts available for investment, according to Paul Hutchinson, sales manager at Investec Asset Management.
He says this has transformed what was previously considered the staid corner of the asset management landscape, dominated by the duration decision (choosing a one-year fixed deposit versus a 10-year government bond, for example) to include a range of yield-enhancing instruments.
“The ability to make use of a myriad investment opportunities to diversify risk and enhance the yield of a portfolio has proven attractive and beneficial to investors.
“This is particularly so now, given the increased volatility of the equity market and the lower real interest rate environment, with consequently lower money market returns relative to history,” says Hutchinson.
He says flexible fixed income unit trusts have become sought after with the relatively low returns from most asset classes.
“It has been a difficult investment environment for the past four years and we have seen it reflected in the returns over that time, so it has been difficult for most funds to deliver real returns over a one to three-year period.
“In this environment, flexible fixed interest funds have seen more flow into them given that they have been delivering somewhat ahead of inflation and ahead of cash on average,” says Hutchinson.
He explains that flexible fixed interest unit trusts target conservative investors looking for a yield pick-up over cash through time. Broadly these types of funds offer consistent cash-plus returns through time, which is relatively appealing to the conservative investor.
“Appetite for these funds is coming from investors who have traditionally hidden in cash and are looking for a higher return, or investors who may have been in the market in a low equity fund and are looking to de-risk their portfolio.
“The fixed interest unit trust is ideally suited to investors who do not want to make the complex asset allocation decision between the growing (in number and complexity) range of fixed-income/yield enhancing instruments.
“As investors continue to derisk their investment portfolios, lower-risk flexible income mandates have become increasingly attractive. It is also at times of increased market volatility that cash seems like the safer bet. However, it comes at the price of lower longerterm returns (and possibly negative real returns).
“Flexible fixed income unit trusts suit investors seeking to maximise real returns over the longer term, while aiming to protect investor capital over the shorter term, which includes investors making use of retirement products (retirement annuities, preservation funds and living annuities) and those who require an immediate income from their invested capital,” says Hutchinson.
The advantage of flexible fixed income unit trusts are more consistent returns through time — many such funds don’t have as much exposure to offshore assets in the portfolio, so there is not as much currency volatility in the portfolio; and lower volatility from less equity exposure, less property exposure and less currency exposure.
As an example, he says Investec’s Diversified Income Fund has combined long and short-dated bonds (both corporate and government), inflation-linked bonds, property loan stocks, debentures, fixed deposits, preference shares and listed property to create a unique outcome for investors looking for lower risk and real returns. “The fund is a comprehensive fixed income solution that aims to maximise income and grow capital. Essentially, the fund seeks to generate real returns while managing downside risk.
“The fund has provided a consistent total return in excess of cash/inflation over time, with some correlation to the bond market when the bond market outperforms, and little to negative correlation to the bond market when it underperforms. It has avoided quarterly capital drawdowns and eliminated sixmonthly drawdowns completely.”
Hutchinson advises that potential flexible fixed income unit trust investors should take into consideration the fact that with the less volatility and more consistent returns you do have a lower returns potential over the medium to long term. Also, the bulk of the returns from such a fund are interest income in nature, which is potentially more penal with regards to tax than capital returns or dividends from equities.
Investec’s Diversified Income Fund, which returned 8.4% pa for the three years to June 30 2018, compared favourably with the All Bond Index (Albi) (7.8% pa) and cash (7.3% pa), meeting its return objective over this period.
The fund was designed to deliver a positive return when the bond market turned negative. It also participated when the bond market rallied, meeting its return objective.
“Importantly, this ability of the fund to participate in bond market rallies and to protect the portfolio during bond market sell-offs is not just evident over the past few years, but the fund has delivered on this dual objective over the longer term since August 2010 during periods when the Albi outperformed cash (about 65% of the time) and when the Albi underperformed cash (about 35% of the time).
When the Albi outperforms cash (which on average it does by 6.8%) the fund participates in these rallies, capturing about 40% of this outperformance and when cash outperforms the Albi, the fund protects the downside and returns almost 1.7% above cash.
“As a result, the fund has outperformed the Albi over the full period, providing a return of more than 2% above cash delivering upside exposure with downside protection, which is in line with its dual objective,” says Hutchinson. The flexibility of the mandate of flexible fixed interest unit trusts is what is proving attractive to investors.
THE FUND IS A COMPREHENSIVE FIXED INCOME SOLUTION THAT AIMS TO MAXIMISE INCOME AND GROW CAPITAL