Investors need to broaden their horizons and turn to less obvious areas of the market to achieve attractive levels of income, according to Heartwood’s Jaisal Pastakia (pictured). 
The investment director at Heartwood Investment Management says the firm has been diverting its attention away from traditional assets such as equities, most of which are trading on historically high valuations, and bonds, which are offering very low yields due to ultra-loose monetary policy.
Instead, the team is opting to seek income in less conventional areas of the market that aren’t as expensive and still offer attractive pay-outs.
“The search for income is becoming more challenging in a low growth, low yield environment,” Pastakia said.
“In our view, the key to a successful income strategy is to deliver consistent and stable pay-outs over the long-term without taking unnecessary risks. For this reason, we have diversified some of our exposure into the niche instruments with a view to reducing portfolio risk and also taking profit in areas where valuations now look less compelling.”
In the below article, the investment director talks through the more “esoteric” areas of the market that he is seeing the best income opportunities in.
Equity overwriting strategies
“Here, the yield from a diversified equity portfolio can be enhanced via a strategy of selling call options,” Pastakia explained.
“This involves one investor selling the optionality to another investor to buy a stock at a fixed price above the current market price. Selling call options adds incremental income to the portfolio. This strategy also helps to lower the portfolio’s volatility, while increasing the yield.”
One fund that Heartwood is using to utilize the benefits of equity overwriting strategies is RWC Enhanced Income, which is benchmarked against the FTSE All Share and resides in the IA Specialist sector.
It has been headed up by John Teahan, Ian Lance and Nick Purves since its launch, all of whom ran income funds for Schroders until the firm bought a 49 per cent stake in RWC Partners.
The £319m SICAV aims to pay out a consistent annual yield of 7 per cent through the use of its yield enhancement strategy, while also both protecting and growing investors’ capital. Not only does it seek to deliver attractive real returns over a market cycle, it also aims to do so with less volatility than its FTSE All Share benchmark.
Since its launch the fund has generated a total return of 19.12 per cent, underperforming the FTSE All Share by 18.22 percentage points. However, it must be noted that this doesn’t take an entire economic cycle into account and that the fund has achieved this performance with an annualised volatility of 7.58 per cent compared to the benchmark’s volatility of 11.21 per cent.
Performance of fund vs index since launch
Source: FE Analytics
RWC Enhanced Income has a clean ongoing charges figure (OCF) of 1.11 per cent and yields 7 per cent.
UK small-cap equities
While investors may associate small-caps with growth as opposed to income, Pastakia says the market area has greater dividend cover on the whole compared to UK blue-chips.
What’s more, he points out that they are far more likely to grow their dividends rather than pay out a flat amount or cut dividends, which has been seen among a number of FTSE 100 stocks over recent months.
“Small-cap stocks are typically less affected by global pressures, such as global deflation, China and commodities, given their domestic demand focus,” the investment director added.
“This is an important consideration if investors take the view that the current low growth, low yield environment is likely to persist for some time yet.”
A UK small-cap fund that Heartwood likes is Montanaro UK Income, which has five FE crowns and is run by Charles Montanaro.
The fund is £127m in size and predominantly invests in UK small and mid-caps although it is also able to invest in quoted European companies as well – examples of the fund’s largest holdings include Taylor Wimpey, Jupiter Fund Management and self-storage company Big Yellow Group.
Most of the fund’s holdings have a market cap of between £1bn and £2.5bn, although it also has a 4 per cent weighting in holdings that are under £250m in size and 10 per cent in companies that have a market cap of between £5bn and £10bn.
Over five years, the fund has made a total return of 55.16 per cent, outperforming its sector average by 11.79 percentage points. However, it has done so with a bottom-decile annualised volatility and maximum drawdown, which measures the most potential money lost if bought and sold at the worst possible times. This suggests that the fund may be better-suited to an investor with a strong stomach for risk.
Performance of fund vs sector over 5yrs
Source: FE Analytics
Montanaro UK Income has a clean OCF of 0.36 per cent and has a historic yield of 1.1 per cent.
Infrastructure debt
“Since banks have retreated from lending under increasing regulatory pressure, opportunities are now opening for specialist investors to enter into the economic infrastructure debt market, which includes industries such as transportation, utilities and telecommunications,” Pastakia said.
“Infrastructure debt can offer several advantages over corporate bonds. As well as providing higher yields, the default rate post the construction phase of an infrastructure project has been lower than for corporate credit, and the recovery rates are meaningfully higher.”
“Furthermore, from a portfolio construction perspective, infrastructure typically has a low correlation to equities and bonds, therefore offering investors an alternative return stream.”
Heartwood are choosing to play this theme through the Sequoia Economic Infrastructure Income fund, a closed-ended investment trust that is £297m in size and aims to provide a net annual return of between 7 and 8 per cent.
Over the last year it has provided a total return of 3.5 per cent, which is the second-lowest total return in the IT Infrastructure sector over this time frame. However, the fund was only launched in March last year and has managed to grow its dividend yield significantly over this time frame – while the fund’s historic yield for 2015 was 1.96 per cent, it currently has a yield of 4.8 per cent.
Performance of trust vs sector over 1yr
Source: FE Analytics
The trust, which has investments in the UK, Europe, Australia, Canada and the US, currently holds 15 infrastructure bonds and 19 private debt investments – these span across various assets including utilities, roads, railways, power and aircraft leasing. Some 54 per cent of the portfolio is also made up of floating rate assets, which means that the trust’s yield is likely to increase as LIBOR increases.
Sequoia Economic Infrastructure Income is currently trading on a 6.2 per cent premium, which is significant but nevertheless lower than its one-year average premium of 8.32 per cent.
Targeted property exposures
While property has divided investors’ opinions over recent months, Pastakia says that the key is to target exposure in individual holdings rather than take broad market exposure.
“We are taking exposure to vehicles that invest in smaller ‘lot sizes’ and where yields are more attractive,” he explained.
“Such parts of the market have not experienced the same amount of yield compression seen in larger lots, as a result of institutional buying.”
“Prime London property remains an important focus, but we are also investing in opportunities outside of London within offices, industrials and warehouses.”
Heartwood holds Custodian REIT in its portfolio, which predominantly invests in smaller commercial lots across the UK – its recent acquisitions include Reiss and House of Fraser stores in Guildford, a yet-to-be-developed Morrison Utility Services store in Stevenage and a Pizza Hut restaurant and Odeon Cinema in Crewe.
Since the trust’s launch in March 2014, it has provided a total return of 11.86 per cent compared to its peer average in the IT Property Direct UK sector’s return of 22.28 per cent.
Performance of trust vs sector since launch
Source: FE Analytics
However, it has a top-decile annualised volatility and maximum drawdown over the same time frame.
