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The Brook Income Fund

Generating income without compromising risk

Tuesday, January 8th 2013, 11:22AM

by Brook Asset Management

Investing in income funds
Traditionally investors tend to derive income from portfolios primarily made up of cash and fixed interest. But the current outlook for defensive assets is far from compelling. The New Zealand Official Cash Rate is 2.5 per cent and the 10-year government bond yield is currently 3.6 per cent, providing a return barely above the level of inflation. The global situation is even more challenging, with most of the developed world facing negative real interest rates and exceptionally flat yield curves.
In this environment the major dilemma facing investors is how to generate acceptable levels of returns from defensive assets.
Investors want a low risk and reliable income stream, but at the same time need a level of return that maintains the purchasing power of their capital at a minimum.

Growth of income funds
The search for alternative sources of income has led to a rapid increase in the popularity of equity income funds.
This is a global phenomenon and, according to EPFR Global, has been the fastest growing global mutual fund investment theme, with $US80 billion worth of flows seen in the past two years .
The rationale for investing in equity income funds is compelling.
In most developed equity markets, the spread between dividend yields and fixed income or cash yields is close to all-time highs.
This is even more apparent in New Zealand and Australia, as both countries have an imputation credit scheme that avoids the double taxation of dividend income, naturally leading to higher dividend payout ratios.
The composition of both markets is also relatively more heavily weighted towards defensive equities, such as listed property trusts or regulated utilities and ports, which tend to have higher dividend yields.
There is an argument to be made that dividend-paying securities are inherently less volatile.
This is firstly because the types of businesses that have high dividend payout ratios tend to be more mature, with more stable and predictable cash flows.
Secondly, because these companies also tend to have lower growth prospects this means that less of the company’s value is based on long-term growth estimates, which are inherently volatile and difficult to forecast.
But less volatility and low volatility are not the same thing and equity risk does not disappear simply because a company pays a dividend.
The chart below illustrates the relative volatility in returns from equities versus fixed interest and cash in the Australian market.

It is also important to differentiate between the volatility of the underlying assets and the volatility of the equity, which can be magnified through the use of leverage.
A classic example of this was the excessive leverage used in the listed property sector in Australia before 2007.
During the Global Financial Crisis the S&P/ASX 200 A-REIT declined by 75 per cent from peak to trough, which was far more severe than the correction in the ASX 200 of 51 per cent.
This is an example of how excess debt can turn low volatility assets into highly volatile equities.
It may be an extreme example, but it highlights an important point - that equity income funds have the potential to be just as volatile as any other equity fund. 
This may be even more relevant for the New Zealand market, given the high proportion of defensive assets and the potential overlap in security holdings. The correlation between equity income funds in New Zealand and the equity market is likely to be very high.

The Brook Income Fund
The Brook Income Fund has been developed to provide a potential solution for investors who are seeking income.
But it has been designed to be significantly different from an equity income fund in that the proportion of equity in the fund is capped at most one third, which creates a significant reduction in volatility.
Brook actively manages the fund by taking an active approach to both the investment strategy and the selection of securities for the fund. The core strategy is to capture risk premiums inherent to fixed-income securities, for example, risk premiums associated with credit, liquidity and duration risk.
The fund is predominantly a fixed-income portfolio, therefore ensuring a low correlation with growth assets, and offers an attractive combination of yield and lower risk than growth assets.
Brook can invest in four major asset classes to actively manage the level of income the portfolio returns.
The four major asset classes are fixed-income securities, cash, hybrid issues such as perpetual notes, and equities.
Where equities are included in the portfolio, there is a strong focus on dividend sustainability rather than capital gain and Brook has capped the percentage of equities to no more than a third of the fund.
There is also no leverage used in the fund. This is to enable the fund to continue to exhibit low volatility and correlation with growth assets.
The investment process starts with the well-established and proven process that Brook has employed since 1997.
Within this process the balance sheet of a company or issuer is evaluated in its entirety, the drivers impacting the business are determined, and the portfolio manager augments this with a qualitative assessment of the company or issuer’s management, as well as the its relative competitive advantages.
We believe the different securities that comprise a company’s capital structure are flip-sides of the same coin. Our fundamental company analysis determines where we can extract a risk premium and therefore add value.
The ability to actively allocate between the four major asset classes the Brook Income Fund can invest in provides Brook with more flexibility to achieve the investment objectives of the fund.
In-depth company research and understanding, coupled with strong internal risk controls, ensures that there is adequate diversification, delivering a credible income producing fund in a diversified portfolio, without compromising the risk characteristics of the portfolio.

Brook Asset Management Limited ("Brook") is a member of the Macquarie Group. The views and opinions expressed in this article are those of the relevant author and do not necessarily reflect the views or opinions of Brook or any other member of the Macquarie Group. This article is based on information obtained from sources believed to be reliable but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. No member of the Macquarie Group accepts any liability whatsoever for any direct, indirect, consequential or other loss arising from any use of any information in this article and/or further communication in relation to this article. Brook is not an authorised deposit-taking institution for the purposes of the Banking Act 1959 (Cth of Australia), and Brook’s obligations do not represent deposits or other liabilities of Macquarie Bank Limited ABN 46 008 583 542. Macquarie Bank Limited does not guarantee or otherwise provide assurance in respect of the obligations of Brook. Macquarie Bank Limited is a company incorporated in Australia and authorised under the Banking Act 1959 (Australia) to conduct banking business in Australia. Neither Macquarie Bank Limited, Brook nor any other member of the Macquarie Group are registered as a registered bank in New Zealand by the Reserve Bank of New Zealand under the Reserve Bank of New Zealand Act 1989 (New Zealand).

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