(PUB) Investing 2016

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Funds That Use Everything but the Kitchen Sink to Produce Income Income Strategist | Janet Yang

Income-Focused Medalists With Lower Volatility When we rate and evaluate investment strategies, we’re basically indifferent to whether returns come from income or capital appreciation. As a result, our recommended income-focused multiasset funds stand on the usual pillars of the Morningstar Analyst Rating—such as having experienced teams and sound investing processes—rather than how much yield they produce; we expect these funds’ total returns to hold up well compared with their blended indexes and allocation peers over a full market cycle. Yet investors looking to draw income from their invest- ments should focus on volatility and credit quality in addition to total return, because they also face sequence-of-return risk that doesn’t affect investors who just buy and hold their investments. We have found some keepers in this group. We’ll tackle them in order of risk. Vanguard Wellesley Income VWINX earns a Morningstar Analyst Rating of Gold for its great combination of fees, management, and strategy. It’s got a mild risk profile yet has pro- duced a five-year annualized return of 8 . 5% and a trail- ing 12 -month yield of 2 . 9% . We’re also fans of Berwyn Income BERIX —a Silver-rated allocation fund. It boasts a 6 . 5% annualized five-year return through the end of August and a yield of 2 . 3% . It’s quirkier than Wellesley but well run by experienced managers. Moving up considerably in risk, we move to tactical allocation fund BlackRock Multi-Asset Income BAICX . The fund has a robust 4 . 8% yield and trailing returns of 7% . Management buys global dividend payers but also dabbles in high-yield, bank loans, and option-writing strategies designed to boost yield. Finally, Bronze-rated Principal Global Diversified Income PGBAX has a very fluffy 5 . 4% yield and 7 . 3% annualized returns. Needless to say, that yield isn’t free. Management loads up on emerging- markets debt, high yield, preferreds, REIT s, and darn near anything else with a yield. Principal farms out the work to various asset-class specialists, and so far they’ve done a fine job. K Contact Janet Yang at janet.yang@morningstar.com

Where can you still find yield these days? Income- oriented funds have yield, but some come with plenty of risk, too. Of the Morningstar Medalists in this group, the lower-risk funds have yields between 2% and 3% , while the high-risk options are up around 5% . More Income, More Volatility When we looked at this group as a whole, we found that the typical income-focused allocation fund lagged a simple blended index after fees even though income-producing securities have been bid up. What’s more, those returns came with greater volatility. Generating a higher yield has meant venturing into more-specialized and volatile areas of the market, such as high-yield bonds, foreign bonds, REIT s, and even utilities stocks. Relying on racier areas of the bond market subjects the funds to more-equitylike risk, which has manifested in higher standard deviations. Income-focused funds only have, on average, a 40% equity stake, but their rolling three-year standard deviations show that their volatilities have been more similar to that of a 60% equities, 40% fixed-income portfolio during the past 10 years through March 2016 . Volatility for a 40% equities, 60% fixed-income port- folio has been consistently lower than both. What’s more, multiasset income funds as a group have not justified those more-volatile results by delivering better returns. During the past 10 years through March 2016 , the typical income-focused fund gained an annualized 4 . 8% with a 9 . 2% standard deviation, while the 40% equities, 60% fixed-income composite index increased 5 . 5% with a 6 . 9% standard deviation; income funds’ lower returns and higher volatility result in worse risk-adjusted results, as measured by Sharpe ratios.