Income: the engine that drives returns

John Stopford of Investec explains why he sees income like a dependable engine, able to drive returns through the ups and downs of the investment cycle.

Total returns consist of yield (the dividends or coupons of equities and bonds) and capital appreciation (the change in the price of those assets). Over the long term and across asset classes, income has proven to be the most important, and dependable, component of total returns.

Since the global financial crisis, unconventional monetary policy has pushed yields inexorably lower. This means that investors seeking a better rate of return must now either aggressively pursue capital appreciation (an approach which has had limited success over the last 20 years) or evolve their investment process.

Our process on the Investec Diversified Income Fund starts with, and is focused on, security selection. We look for securities with resilient yields and the potential for capital stability or appreciation. The yield of these individual securities provides the driving force behind our returns. We then ensure diversification of the portfolio by owning a mix of securities based on their behaviours. We believe traditional diversification ideas, which rely on whether an asset is a bond or an equity, can prove naïve. Finally, we hedge the portfolio when the risk environment appears to be dangerous. Just as an engineer cares about the nuts and bolts, we care about bottom-up security selection.

Security selection, not asset allocation

We believe a process of selecting resilient income generating securities to act as an engine for performance can, in combination with appropriate risk-management, produce defensive returns. These attributes are useful not just in the current late-cycle turbulence but in any environment. The Investec Diversified Income Fund seeks to produce a defensive return with less than half the volatility of the equity market. It seeks to use assets with an above average yield to drive performance.

Income as an engine

We see income as a more dependable source of return generation than capital appreciation. The blue areas of the bars in Figure 1 show that over the long term, income has been the most important component of total return. This is true across asset classes.

Source: Bloomberg, in USD, 30.11.18. Period shown is since 31.12.98.

Yield is harder to find

Given the pervasive decline in yields following the 2008 financial crisis, investors must now increasingly rely on aggressive capital appreciation for gains (which given historical precedent could be a misplaced hope) or accept a lower rate of return. We aim to solve this problem by building the Fund from the bottom-up (rather than relying on passive exposure or other managers), which provides a greater number of opportunities, control of risks and precision.

Resilient yields, not just high ones

We pick every position based on its potential for total return. Looking simply for the highest level of yield is not enough, because often a high yield is a risk indicator. An inflated yield could either suggest investors want their money back as quickly as possible, or the yield is unsustainable and likely to be cut. Looking at individual securities, we find that higher dividend stocks produce better returns than lower ones, but the pattern isn’t uniform. Given our desire to balance returns, volatility, and drawdown, the best mix sits with yields which are higher than average, but not the highest.

A concise, differentiated portfolio

In short, there are many ways to drive returns. We believe a process that starts with, and is focused on, resilient income-generating security selection is the best way to generate defensive returns. This is important not just for the current climate, where yield is harder to find, and aggressive capital appreciation tactics aren’t likely to work, but during any time when investors are looking for a more reliable source of capital. Which is why we see income like a dependable engine, able to drive returns through the ups and downs of the investment cycle.

Issued by Investec Asset Management

Performance targets are subject to change. The portfolio may invest more than 35% of its assets in government securities issued or guaranteed by a permitted single sovereign entity, as defined in the definitions section of the Fund’s prospectus.

This communication is for institutional investors and financial advisors only. It is not to be distributed to the public or within a country where such distribution would be contrary to applicable law or regulations. Nothing herein should be construed as an offer to enter into any contract, investment advice, a recommendation of any kind, a solicitation of clients, or an offer to invest in any particular fund, product, investment vehicle or derivative. The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market views presented herein reflect Investec Asset Management’s judgment as at the date shown and are subject to change without notice. There is no guarantee that views and opinions expressed will be correct, and Investec’s intentions to buy or sell particular securities in the future may change. The investment views, analysis and market opinions expressed may not reflect those of Investec as a whole, and different views may be expressed based on different investment objectives. English language copies of the Fund’s Prospectus and Key Investor information Documents are available from Investec Asset Management on request. Issued April 2019.