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Funds

Will You Sacrifice Returns for Income?

Multiasset income funds often pursue yield at the cost of total return.

We recently released a study of the generally disappointing results that much-hyped objectives-based investments have delivered to investors. A summary of the research can be found here and the full paper here. Today's article looks more closely at income-focused multiasset funds, the most popular subset of objectives-based investments.

Investors' desire for higher income is nothing new, but the past seven years' low-yield environment has made the task more difficult. In that sense, income-focused funds have offered some relief: Our review of multiasset income funds shows that they roundly deliver higher yields than the typical allocation fund, as well as a simple blended index.

Exhibit 1 presents rolling 12-month yields for income-focused funds compared with non-income-focused multiasset funds, as well as a 40% equities/60% fixed-income blended index.[1]

Exhibit 1. Income-Focused Funds Deliver Income Rolling 12-month yield, April 1, 2006, to March 31, 2016

Source: Morningstar, Inc.

Income-focused funds consistently have higher yields. That makes sense. As part of our study, we placed funds into the income group based primarily on prospectus language that stressed current income as a primary objective. This eliminated a number of funds that had "income" in their names but also had lower yields because their prospectuses also emphasized growth and appreciation objectives.

More Income, More Volatility But the question is how these income-focused funds achieve those yields, and the opportunity cost of doing so. Despite a multiyear bull market for income-producing securities, during the past decade through March 2016, the typical income-focused fund lagged a simple blended index after fees. What's more, it was more volatile, a salient detail given that volatility can exacerbate the sequence-of-return risk that investors court when drawing investment income (that is, those investors gradually sell their investments and in so doing potentially lock in market losses).

Generating a higher yield has meant venturing into more-specialized and volatile areas of the market such as high-yield bonds, foreign bonds, REITs, and even utilities stocks, as shown by Exhibit 2 (we divided the asset classes into two separate charts to preserve the scaling details for asset classes with smaller allocations).

Exhibit 2. An Intrepid Search for Yield by Income-Focused Funds

Rolling 12-month yield, April 1, 2006, to March 31, 2016

Source: Morningstar, Inc.

Relying on racier areas of the bond market--such as lower-rated credits, emerging-markets debt, and bank loans--subjects the funds to more equitylike risk, which has manifested in higher standard deviations. Income-focused funds have, on average, only a 40% equity stake, but their rolling three-year standard deviations have been more similar to that of a 60% equities/40% fixed-income portfolio during the past 10 years through March 2016. Volatility for a 40% equities/60% fixed-income portfolio has been consistently lower than both.

The average income-focused fund has also lagged the returns of a 40% equity/60% fixed-income blended index. As shown in Exhibit 3, during the past 10 years through March 2016, the typical income-focused fund gained an annualized 4.8% with a 9.2% standard deviation, while the 40%/60% composite index increased 5.5% with a 6.9% standard deviation; income funds' lower returns and higher volatility result in worse risk-adjusted results as measured by Sharpe ratios. The average income-focused fund costs 1.20% per year (based on the oldest share classes), which implies that managers of income-focused funds have successfully juiced returns before fees but not after.

Exhibit 3. Income-Focused Funds Have Higher Standard Deviation, Lower Return Than Blended Index

10-year annualized returns, standard deviations, and Sharpe ratios, April 1, 2006, to March 31, 2016

Source: Morningstar, Inc.

Our attribution analysis shows that while income-focused funds have benefited from asset-allocation decisions, it's not necessarily attributable to allocation skill per se. Instead, at least some of the positive allocation effects come from income-focused funds being systematically invested in a segment of securities (income-producing ones) that have been in favor for much of the past five years. If investment styles and asset classes come into and out of favor over time, we would expect the positive and negative allocation effects from income-focused funds' systematic allocation biases to essentially cancel each other out. Attribution analysis also suggests that the typical income-focused portfolio manager's stock and bond picks don't materially add to results, on average.

Medalist Income-Focused Funds With Lower Volatility When we rate and evaluate investment strategies, we're indifferent to whether returns come from income or capital appreciation. As a result, our recommended income-focused multiasset funds stand on the usual pillars of the Morningstar Analyst Rating--such as having experienced teams and sound investing processes--rather than how much yield they produce; we expect these funds' total returns to hold up well compared with their blended indexes and allocation peers over a full market cycle. Within income-focused funds, 11 are Morningstar Medalists.

Yet investors looking to draw income from their investments should focus on volatility and credit quality as well as total return, because they also face sequence-of-return risk that doesn’t affect investors who just buy and hold their investments. During a given time period, if most of an investment's worst returns come at the beginning of the period, income-drawing investors will have lower account balances than if the worst returns come at the end; this is because the income taken out doesn't have the chance to grow and compound from the higher returns experienced later on.

Investments with lower volatility and lower downside capture can help guard against this risk, so Exhibit 4 shows the subset of medalist, income-focused funds that we believe will ably serve investors who intend to draw regular income from these investments. These multiasset income-focused funds have Morningstar Analyst Ratings of Gold, Silver, or Bronze and also tend to have lower volatility and lower downside capture (such as a five-year downside capture ratio consistently lower than 100) compared with peers.

Vanguard Wellesley Income VWIAX

Fixed-income portfolio manager John Keogh and equity manager Michael Reckmeyer manage their 65% and 35% sleeves of the fund, respectively, using a balanced approach to providing income, capital appreciation, and downside protection. The fund has lately derived its top-quartile, 2.8% trailing 12-month yield from a bond portfolio with no high-yield bonds and stocks that, on average, have less debt and higher returns on assets than its typical peer's holdings. The fund's rock-bottom fees make it one of the cheapest actively managed allocation funds around and give investors a discernable performance head start. --Alec Lucas

Berwyn Income BERIX

The team here takes a contrarian approach, preferring to avoid hot parts of the market and buying what is out of favor. The fund can invest as much as 30% of its assets in dividend-paying common stocks. Beyond a dividend, management looks for companies of all sizes with improving balance sheets and good cash flow prospects that trade relatively cheaply--often because of short-term issues. The rest of the portfolio is split among corporate bonds, preferred stocks, and convertible securities. Within corporates, the team has focused on BBB rated debt and high-yield securities, although it usually avoids the lowest-rated debt. --Kevin McDevitt

BlackRock Multi-Asset Income BIICX

Lead manager Michael Fredericks can shift his portfolio across myriad income-generating asset classes with few constraints, typically holding 20%-40% of assets in equity-income securities, 40%-60% in fixed income, and 20%-40% in alternative income securities, such as master limited partnerships, REITs, preferred stock, bank loans, and emerging-markets debt. He can also use futures, options, and shorting to hedge various risks, including equity, interest-rate, yield-curve, and currency risks. While the fund may move in and out of asset classes with ever-changing risk profiles, Fredericks aims to keep the fund's average 30-day volatility below that of the 50% MSCI World/50% Barclays U.S. Aggregate Bond Index blended benchmark, and it has generally stayed well below that threshold. --Jeff Holt

Principal Global Diversified Income PGDIX

This multimanager fund invests in over a dozen distinct strategies across nine asset classes, and this diversification has smoothed returns as the strategies have taken turns shouldering performance. Management emphasizes the risk-adjusted yields of each underlying asset class to construct the overall portfolio, and it sets constraints to prevent any asset class from overwhelming the fund as part of the effort to balance the portfolio's overall yield and risk. The fund uses both Principal-affiliated and external managers to gain access to U.S. high-yield bonds (which had a 33% target allocation as of March 2016), emerging-markets debt (21%), commercial mortgage-backed securities (17%), global infrastructure (8%), global value equities (6%), preferred securities (6%), global REITs (4%), master limited partnerships (3%), and non-U.S. developed-markets high-yield bonds (2%). --Jeff Holt

[1] The blended index reflects the average equity allocation for income-focused funds, with non-U.S. equities representing 30% of the composite's total equity sleeve. We generally used the S&P 500 to represent U.S. equities, the MSCI ACWI ex USA Index for non-U.S. equities, and the Barclays U.S. Aggregate Bond Index for fixed income. For Exhibit 1, we used the exchange-traded funds of the indexes in order to calculate a weighted average yield for the blended index. The composite consists of 28%

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