Chasing Yield, Losing Wealth: Steps to Avoid the Biggest Income Fund Mistakes

When you are investing for income, you are looking for capital preservation, a level of growth and consistent income. But what if the fund you pick fails to deliver? Worse still, what if your money is lost?

Many investors worldwide have been faced with such a challenge.

The collapses of First Guardian Master Fund and Shield Master Fund in the last year targeted investors close to, or already in retirement with promises of unrealistically high returns. Losses were substantial, with investors still chasing even some level of recourse. The repercussions have been wide-ranging – managed funds also invested into these funds, not just direct retail investors.

For example, the Clime Australian Income Fund is one such fund that is alleged to have invested in the failed schemes. It is currently under a preliminary investigation by ASIC, and was closed last year.

Another recent concern for income investors is the collapse of UK lender Market Financial Solutions, which has affected a number of private credit providers who had exposure, including Australian fund manager Realm Investment House – though Realm noted the exposure was 0.8% of the total assets under management, a demonstration of how critical diversification really is as a protective measure.

When it comes to avoiding income fund mistakes, there are a few key steps to remember.

Lesson 1: Set your investment goals and remember inflation

Before you invest in any fund, you should know what you actually need from your strategy – both your income needs and growth to continue delivering on your strategy. It also pays to spend the time considering how inflation may shift your goals.

An example of a typical income goal might be CPI + 2-3% to manage the impact of inflation and factor a buffer on top for the future.

From there, you’ll need to map out how to blend your investments to achieve this.

This means some investments which might return less than that stated goal because they offer consistency, for example, using a term deposit which has a fixed return that may end up below inflation over time, alongside investments which offer potentially higher risk (but also the potential of higher returns), like private credit investments or equity income or even blended fixed income funds.

Starting with this approach helps to avoid the common mistake of insufficient income or growth in retirement. It also allows you to assess your risk needs so if a fund targets high income but comes with a high level of risk, you’ll know before you invest whether it is a suitable option for you or not.

Lesson 2: Consider total return

A common mistake made by income investors is to focus purely on yield – especially if it claims a high yield. This is how many investors end up in dividend traps or high-risk strategies that aren’t suitable for them, such as in the First Guardian and Shield Master Funds situation.

Remember that high yield doesn’t guarantee those critical components of income, like consistency and stability. And, as they say, if it sounds too good to be true, it probably is – any income fund promising double-digit long-term returns is likely to be higher risk than a standard income investor is actually able to budget for in their portfolio.

What you want to consider instead is total return.

Total return is growth (capital appreciation) and income returns (whether interest coupons or dividends) over time. As part of this, consider the total returns after fees, as fees can really diminish the income and growth you receive.

Income investors need a level of growth as part of their future needs and protection against inflation which is why you need to look at the sum of the whole, rather than just the parts.

Some funds will even set their objectives on a total return basis, for example, the Mutual Income Fund specifies a target of total returns above the Bloomberg Ausbond Bank Bill Index (after fees) over a rolling 12-month period or the Intelligent Investor Australian Equity Income ETF (ASX:INIF) which targets a total return of 1% above the S&P/ASX Accumulation Index p.a. and a distribution yield of 2% greater than the Intelligent Investor Growth Portfolio over rolling five year periods after fees.

Lesson 3: Diversification

Spreading your investments across different assets with different income streams is protective, particularly in periods of volatility. It is also protective to consider more than one form of fund so that if something goes wrong, you still have assets elsewhere as a buffer.

Traditionally, investors used fixed income investments as their primary form of an income stream – fixed income should still form part of an income strategy, after all, it can offer consistent stable returns, particularly where you use government bonds from stable economies like Australia. Even within these funds though, there should be diversification across duration.

Some examples of this are MST Australian Bond Fund which invests across government and corporate bonds, asset-backed securities and cash and in different durations, or Arculus Preferred Income Fund which uses Australian government and semi-government bonds, corporate senior and subordinated bonds and cash.

Beyond this, a range of other assets can offer income and growth, such as equities (using dividends as income), private credit and property. Remember to use both domestic and international investments as part of your diversification strategy, and consider how you blend the different asset classes to achieve your income and growth goals.

Some examples of other income producing asset funds include Plato Global Shares Income Fund which invests in dividend-paying global equities, Remara Private Credit Income Fund which focuses on a range of asset- and mortgage-backed securities, alongside other opportunities in the private credit sector and MPG Property Income Trust which invests in unlisted property trusts managed by MPG, alongside listed property trusts to generate monthly income.

Lesson 4: Manage tax and franking

As they say, the only certainty is death and taxes, so don’t forget tax implications when you invest in income funds.

One common mistake that investors make is forgetting to consider tax consequences of income-producing assets and what that means for their final income results – this can mean the tax you need to pay, particularly on foreign assets, but it can also mean forgetting the value of franking credits for Australian dividend-paying companies.

Using franking credits is a common strategy used by zero-tax investors, like retirees, to boost their income – but bear in mind it can still be valuable from a tax perspective even if you aren’t in this bracket yet.

Some Australian equity funds specifically factor franking credits as part of their income targets, for example, WAM Income Maximiser ltd (ASX: WMX) which targets franked dividends, as does the Plato Australian Shares Income Fund (this is designed specifically for zero tax investors to utilise franking credits).

Lesson 5: Liquidity and cash

The biggest fund crashes have often been linked to liquidity problems – investing in illiquid assets that weren’t suitable for the investor profile. This was one of the issues with the Shield Master and First Guardian fund collapses.

Income investors should consider further how liquidity ties into their strategy and needs.

Illiquid assets can still offer consistent income, but might be challenging if an income investor needs to urgently free up cash for their income needs for example. You’ll need to ensure you balance any use of illiquid assets, be it within a diversified fund or a key asset, against your broader portfolio.

Property investments, as an example, are typically iliquid investments, although they can offer regular rental income and growth from appreciation in value in the property market.

On the flip side, focusing your liquidity on a high cash balance can also be a problem for income investors. Why? Interest on cash won’t beat inflation, so you are risking growth and potentially better returns by not investing in other assets. Cash should still form part of your portfolio to offer both liquidity and an element of capital protection but shouldn’t form the bulk of an income portfolio.

Take the Time for Income that Pays

Investing for income, particularly in retirement, comes with a range of challenges but avoiding the mistakes comes down to being mindful of your goals and strategy, careful diversification across asset classes, sectors and regions and looking at total returns rather than simply chasing high-yield.

Just as with any other strategy, research and the fundamentals – like fund manager expertise and track record – must also form a part of your investment decisions.

Patience pays off in the investing world. It’s often the snap decisions that hit you later and that is particularly true for income investing where the time you take to set off your income streams will help you in years to come.

Funds Mentioned

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.