4 questions to ask of income-focused funds

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 Barclays 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:
  1. 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.
  1. 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).
  1. 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.
  1. 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.
1 All index data as of December 21, 2015 unless otherwise noted.Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management. Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index). S&P 500® Index: An index, with dividends reinvested, of 500 issues representative of leading companies in the U.S. large cap securities market. A market-capitalization-weighted index maintained by Morgan Stanley Capital International (MSCI) and designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The MSCI All Country World Index Ex-U.S. includes both developed and emerging markets Morgan Stanley Capital International All Country World (MSCI ACWI) Ex-U.S. Index: A market-capitalization-weighted index designed to provide a broad measure of stock performance throughout the world (with the exception of U.S.-based companies), including both developed and emerging markets. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Copyright © Russell Investments 2016. All rights reserved. Russell Financial Services, Inc., member FINRA, part of Russell Investments. RFS 16449
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