Recent news about the demise of the Third Avenue Focused Credit Fund has brought the importance of fund due diligence back to the forefront. In a low yield environment, with the Bloomberg U.S. Aggregate Bond Index yielding 2.5%, the S&P 500®
Index yielding 2.2%, and the MSCI ACWI ex-U.S. Index yielding 3.3%,1
many investors have reached farther out on the risk spectrum to find higher yields
But, higher yield comes with more risk
. For those investors who are using the yield from their portfolio to generate retirement income, taking that additional risk might be detrimental
to achieving their long-term goals of a sustainable, repeatable, dependable source of income.
The Internet is full of useful checklists – how to make packing for a trip easier, how to find a nanny like Mary Poppins – but it doesn’t offer much guidance on the key questions investors and their advisors should consider
asking before investing in mutual funds. So, consider the following four questions as a starting point for evaluating income-focused funds:
- How much of the fund’s portfolio is invested in high-yield (junk) bonds?
Why this matters – The yields on these bonds are generally higher than traditional corporate bond yields for likely one of two reasons: Either the company’s prospects are uncertain or they already have issued a lot of other debt that is higher in the capital structure and will get paid first. These assets can also be illiquid, or thinly traded.
It’s telling that these bonds are typically called “high yield” when their performance has been good, but “junk” when their performance has been terrible.
- Does the fund have a particular sector concentration?
Why this matters – The search for yield may tempt many funds to concentrate their investments in a single or limited number of dividend yield sectors
. Utilities, telecomm, and energy have typically been seen as higher yielding opportunities. Currently, these sectors (represented by S&P 500 Index sectors) offer yields of 3.9%, 5.2%, and 3.8% respectively (as of December 21, 2015). Income-focused funds may have high allocations to these sectors.
Income funds too narrowly focused on a specific sector can potentially have significant negative returns
. As an example, while energy is the second highest yielding sector, consider its returns over the last 12 months with the S&P 500 Energy Index posting a -24.2% return (as of December 21, 2015).
- Does the fund have a home-country bias?
Why this matters – A home-country bias
may cause investors to miss out on yields abroad
that may be higher than those offered in the U.S. For example, as of November 30, 2015, certain countries such as the UK (3.6%, represented by Russell United Kingdom Index NR USD) and Australia (7.0%, represented by Russell Australia Index NR USD) offer higher yields than the U.S. (2.2%, represented by S&P 500 Index), but may come with additional risks.
- How large is the fund?
Why this matters – Very large funds are often major shareholders in particular issuer names, thus may have trouble liquidating positions
if it becomes necessary to do so. Additionally, larger funds may not be able to take advantage of higher-yielding smaller debt issuers because at the fund level, the allocation may not make a meaningful difference.
The bottom line
Knowing what your clients own is critical. Asking the right questions is only the first step. Taking action and reviewing your clients’ current or potential income funds is the second step. Consider taking time early this year to find the answers to these four questions on behalf of your clients.
All index data as of December 21, 2015 unless otherwise noted.