Question:

I am retired and rely on a regular income from my investments. I have invested in an “enhanced income”-type fund that is supposed to deliver returns better than cash or a typical money market fund, with a return target of cash + 1-2%. Recently the returns have fallen below this target and my income has suffered – what has happened and what should I do?

Answer:

Funds that aim to deliver a high level of regular income that beats cash must invest in a combination of assets that give you both 1) a steady income stream, and 2) some capital growth over time, in order to beat bank deposit rates and income-only funds like money market funds. Therefore, they need to invest in a high proportion of income assets like cash and bonds, as well as a smaller amount of growth assets like listed property and even some equity. This also makes them riskier than cash or money market funds.

For example, Prudential’s Enhanced Income Fund is holding 42% in SA cash, 31% in SA bonds, 5.3% in inflation-linked bonds, 4% in listed property, 16% in foreign bonds and 1.2% in SA and foreign equity.

Over the past year or so, we’ve seen that most asset classes have produced relatively low or negative returns, including bonds. This has reduced the returns delivered by income-targeting funds. For example, in 2015 South African bonds lost 3.9%, inflation-linked bonds returned 3.7%, South African equities 5.1% and listed property 8.0% -- all very low returns compared to those of recent years.

One of the reasons for negative bond returns has been the rising interest rate cycle in South Africa: higher interest rates erode the capital value of fixed-rate bonds. Historically it has been shown that when the SARB is hiking interest rates, bond returns decline over the short term before improving again as interest rates stabilise and eventually fall.

Partly because of their high bond holdings, returns from enhanced income funds reflect the interest rate cycle. They do comfortably outperform money market and cash returns over periods of two to three years and longer, but there are shorter-term periods (one year or less) in which they are expected to underperform, and do so. Longer-term investors are rewarded for this risk.

It is for this reason that we believe it is important for enhanced income investors to have an investment horizon of between one and three years. We view this timeframe as essential in achieving the additional returns over cash.

During periods of temporary underperformance, we have seen investors make the mistake of switching away from their enhanced income fund to money market funds or a one- or two-year bank deposit offering slightly higher future returns. There are two risks with this strategy: first, investors lock in the short-term underperformance. Second, when the bank deposit reaches maturity after one or two years, the interest rate cycle will have turned so that rates will be falling – the investor will have missed out on potential gains from the enhanced income fund and will be forced to move out of the bank deposit and reinvest at lower rates. This “reinvestment risk” needs to be taken into consideration.

Consequently, even though it may be tempting to switch, income investors like you should try to weather the short-term relative underperformance and stick with enhanced income funds that have proved themselves capable of delivering on their performance targets over the longer term. Please do consult a financial adviser before you make any changes to your current portfolio.