Traditionally, investors seeking income have done so through investing in high yielding equities, and this invariably meant a portoflio of UK listed shares. However, while this approach has stood investors in good stead in the past, the current combination of rising inflation and unsettled equity markets has caused many to rethink their approach.

So how should you go about constructing an income portfolio? Donna Bradshaw, financial planning strategist at IFG Group, suggests that ‘You need to work out first of all exactly what you want to achieve. A lot of people just don’t do the forward planning. Ask yourself how much income you actually require, not only now but what your requirements will be in the future.’

She adds, ‘You also have to understand that investment returns are cyclical. The timing issue is very important. If you are investing to generate income, you need to start well in advance, say five years or more, before you actually need to take that income. That way you can build some of the vagaries of the market into your investment strategy.’

Nick Rundle, associate director at Taylor Young Investment Management, argues that ‘Given that inflation is picking up now, if you are a top rate taxpayer in an unprotected environment, you need to generate 6.25 or 6.5 per cent from your portfolio just to cover inflation, which is a big ask. What people ideally want is to be able to take a stable, and possibly rising, income, while maintaining the value of their capital in real terms, which is very difficult to do without putting that capital at risk.’

Limiting the risks
Jim Stride, of AXA Investment Managers, counsels that ‘The first thing that you need when investing for income is patience. If you are worried about inflation, you get real certainty with index-linked gilts. The headline returns might not be all that great but if you use index-linked gilts then the return will be ahead of inflation.’ He adds, ‘If you were very pessimistic about the outlook for everything and wanted to beat inflation, you would invest in very long dated government issues, and issues made by governments that you were pretty sure were still going to be around to pay the coupon and repay the capital.’

Indeed, bond funds are generally offering higher yields than equity-based funds at the moment (see table on page 18). However, over the longer term, it is unlikely that the level of actual income received from these funds would be able to keep pace with inflation. Rundle confirms that ‘At the moment, if you are heavily invested in cash and taking an income out of your portfolio, then the value of your capital will be declining. The same will apply if you are heavily weighted towards fixed interest. I am pretty committed to equities. I believe that equities are the best protection against inflation over the long term, but you do have to finesse that if you are looking for yield.’

Jim Stride adds ‘the lesson of history is that studies of past performance suggest that you should always invest a slice of your portfolio in equities. And if you are an income seeking investor then you should tilt that towards dividend paying equities, particularly those that are yielding above the index average at the time you invest. You follow this strategy because, in the long run, you expect that there will be a reasonable level of economic growth, plus you anticipate that inflation will be more or less a constant presence, so you will want to have exposure to the equity market.’

Sticking with equities
Equity investments are still likely to form the core of any income portfolio. Charles Luke, of Aberdeen Asset Management, manager of the Murray Income Investment Trust, points out that ‘Underlying the generation of income from equity investments is the ability to increase your dividend over the long term. Also, when you pay a dividend, you need the cashflow to be able to do so, and focussing on this instils a good discipline in corporate managements.’

He adds, ‘That is what investment managers mean when they say they are looking for companies with the ability to grow their earnings and it is very important to be able to do that. Of course, you can manufacture a high level of income, if you want to, by trading a portfolio, but that will incur a lot of costs and you will also be putting your capital at risk.’

Julian Chillingworth, chief investment officer at Rathbone Unit Trust Management, points out that ‘A key point to understand is that, over the medium term, say over five years or so, the greatest return will come from growth in earnings and, therefore, in income. There are figures to suggest that over one year market fluctuations can have an impact on portfolio valuations, but over the medium term you are relying on income and earnings growth.’

Beware the value traps
However, simply because a stock is on a high yield doesn’t necessarily mean it is an attractive proposition. Nick Rundle stresses that ‘You don’t want to be taken in by “value traps”, things that look as if they are on attractive yields but where those yields could easily be cut. You don’t want nasty surprises on the dividend front.’

And Julian Chillingworth argues that ‘When you are investing in the stock market, you don’t necessarily want to buy into the highest yielding shares. What you are specifically interested in is growth in yields because a static yield will show an inferior performance, compared to a share that is growing its dividend by 10 per cent. Income funds go in and out of fashion, and you see this happening at the turn of an economic cycle. In the main, income funds tend to contain more value orientated investments, so they will tend to benefit from an upturn in the economic cycle.’

He adds, ‘If you buy an income fund you need to make sure that the companies it invests in will continue to pay their dividends in the future. You want companies that, at the very least, are going to maintain their dividends and, preferably, are going to grow them.’

Broadening your horizons
So the traditional UK Equity Income Fund still has an important role to play in an income portfolio. But James Harris, manager of the Mellon Newton Global Income Fund, suggests that investors should be looking even further afield. ‘The reason that UK investors have traditionally looked to the UK stock market for income was that there wasn’t much yield overseas, but that is not the case now, as you are seeing the growth of a dividend paying culture around the world.’

He points out that ‘Investors are increasingly demanding that companies pay some kind of dividend. It is a natural product of the maturing of capital markets around the world that dividend payments are becoming more of a feature of corporate policy.’
Harris feels that ‘UK Investors tend to be overly reliant on sterling assets, but I would argue that they should be looking to hold a more global income portfolio. The real dividend yield on global equities is currently as high as it has been for decades and this is underpinned by a relatively low payout ratio. Global equity income is a wider asset class and it offers the benefits of diversification both in terms of markets and diversification away from sterling.’

Spreading the risks
Indeed, diversification is a key strategic element for investors who want to generate a reasonable level of income, while still keeping the risks under control. Donna Bradshaw argues that ‘You should maintain a spread of investments. Investors need to realise that it is not just about equity income. We have had our clients in index-linked gilts over recent months, which have done very well over the past year, and we keep quite a lot in cash, which is very handy when markets are volatile.’ She adds, ‘Investors need to understand that things are cyclical and the importance of diversification.
‘If you take too much risk, that may erode your capital which, in turn, will reduce the amount you have available to generate income.’

Dan Looney, investment consultant at Towry Law, agrees that diversification is a key consideration. ‘Our overriding philosophy at Towry Law is to use several asset classes across our client portfolios, up to 15 different ones. Equity income has had a pretty rough ride over the past year and this illustrates why you don’t want to be overly reliant on one asset class.’

Adjusting your strategy
He adds, ‘Also, with the CGT changes, and income still taxed at 40 per cent for a top rate taxpayer, it may be more tax efficient to take withdrawals, rather than distributions. You need to maintain the capital value of your portfolio and that will help if you are taking withdrawals, as you don’t want the portfolio value to shrink to nothing.’

Charles Luke agrees that ‘At the moment, the market is quite difficult for those seeking income. Over the year to the end of July, only two sectors of the UK stock market generated a positive return – mining and Oil & Gas. Mining stocks only yield around 1.5 to two per cent. Some of the established Oil & Gas companies are good dividend payers, but most of the return has come from exploration companies that don’t usually pay dividends at all, as they are using their capital to make new discoveries.’

And Nick Rundle explains his approach to running a balanced income portfolio. ‘We don’t rule anything out, but you have to invest on a long term basis, following equities you like, such as BG, which might have lower than average yields. So you also have to include some higher yielding stocks, like HSBC or Close Brothers, which can help you compensate for the yield you are giving up on the lower yielding equities.’

Where to invest
So which funds should income investors be concentrating on? Donna Bradshaw confirms that ‘we do like equity income funds, but these are obviously going to be more volatile than cash and investors have to realise that there will be periods when the income that you get from equity investments will go down.’

She adds, ‘It is about maintaining a balance. You have got to look at all forms of investment, even property, although that market is not looking too attractive at the moment. Having said that, people who have held property investments for a long time are still getting a decent yield on it, but those who have been in for a shorter period should probably get out and invest in something else.’

Financial planning firm Principal Investment Management recently published the latest half-yearly update of its Principal Income Study (see box on page 16). Charles Brand, Principal’s director of managed funds, observes that ‘The current mood of pessimism among investors is one we have seen before, and one that is creating bargains for long-term investors. The best way to benefit from this is not to try and cherry-pick individual shares, but to utilise the best talents in the industry to build your portfolio for you.’

Principal’s “White List” of equity income fund managers aims to do precisely this. Brand argues ‘The environment for dividend paying stocks has remained difficult in the past six months and the market has been indiscriminate in its downgrading of the areas traditionally favoured by income seekers.

‘This negative sentiment has pushed dividend yields significantly higher across a variety of sectors. This is creating a range of opportunities for income investors, the likes of which have not been seen for a number of years.’