How to choose an Income Fund

20 April 2016

Nancy Mills, Insight Analyst (Funds)

Income funds, as the name suggests, pay out an income to the investor on a regular basis (normally monthly, quarterly or half yearly). They are likely to be managed in one of two ways;

  • Investing in a mixture of income producing asset classes; equities paying dividends, bonds, property and possibly other income producing assets. These assets can be held directly or through other funds. The mix of these asset classes will differ from one fund to the next and some will invest in more ‘risky’ income producing assets such as emerging market debt, high yield bonds and infrastructure to gain extra yield.
  • Investing as above but using derivatives to ‘smooth’ the returns. The derivatives, if managed well, will have the effect of ‘topping up’ the fund’s income but will sacrifice some of the returns in order to pay for their cost.

Some investors will hold income funds during the accumulation stage and reinvest the income as a way of boosting growth. However, for most investors, the requirement to purchase an income producing fund arises during the decumulation stage of their lifecycle, as opposed to the accumulation stage i.e. at or during retirement. The choice of income fund depends on many things. The main considerations for post-retirement investment are to minimise volatility, generate a regular and stable income, to preserve capital for inheritance purposes and maintain flexibility (access to capital).

The total return for any fund can be broken down into income and the capital gain or loss. The total return and the income and capital return components will each have an associated volatility or risk. As with all investments, there will be a trade-off between risk and return. In the decumulation phase, an added consideration to overall risk and return is the trade-off between income levels and capital preservation.

It is necessary to understand what is most important to the investor and that they understand the trade-offs they have to make in order to get what they need, in terms of income and capital preservation. Funds are likely to be managed with one of the below aims;

  • Maintaining capital while producing some income.
  • Producing higher and possibly growing income but with the possibility that capital could be reduced to zero at the end of the investor’s time horizon (or before).
  • Somewhere in between the two – where some capital is at risk in return for a level of income that is higher than that in the first example.

Once the investor has decided upon one of the options above and understands the benefits and trade-offs of their choice, then general fund selection factors will apply when deciding which income fund to select; strength of the underlying business, quality of fund managers, costs and performance, together with some income fund specifics; including number of payments per year and yield.

At Defaqto, we will soon be launching a new Diamond Rating for Income Funds. We will be using some income specific criteria to help calculate the overall Diamond Ratings. These include;


  • Mandate – we prefer those funds that state a mandate and stick to it i.e. they deliver what they say they will deliver.
  • Annualised post tax yields.
  • Risk adjusted returns, particularly concentrating on the downside risk – we favour those funds that don’t suffer heavy losses at any one point in time; losses in the decumulation phase are more difficult for an investor to recoup.
  • A capital preservation measure – we favour those funds that maintain their capital levels without having numerous ‘dips’ below the original investment amount; in order to preserve income levels, the capital needs to remain stable.
  • Number of payments per year – frequent income payments being favoured over infrequent payment options, as most investors will be looking for a salary replacement.  




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