20 high-yielding active fund favourites

Specialist high-yielding funds pack an income punch - but sometimes at a price, writes Tom Bailey.

Interest rates have been at historic lows for the past decade and more, forcing down savings rates and fixed-income returns. As a result, income investors have become desperate in their search for investments that make regular, reliable payouts.

However, they need to be careful and consider the cost of such investments, especially given that the values of many of these funds have been boosted by increased demand for them.

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Yield will be a key measure in this process. It can be calculated in different ways, but the widely used measure is historic yield: an asset’s dividend over the previous year expressed as percentage of its current share price. This means that a drop in the price of an asset produces a higher yield, and vice versa.

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In the hunt for income, investors in the UK can always look to the FTSE 100 index, which has historically been a rich source of generous dividend-paying companies. The blue-chip index currently yields 4.4%. That’s decent compared with other developed markets around the world – the US’s S&P 500 index, for example, yields just 1.8%. Investors can gain low-cost access to the FTSE 100’s fortunes and dividend payouts through a variety of index tracker funds and exchange traded funds (ETFs). BlackRock’s iShares Core FTSE 100 UCITS ETF, for example, charges just 0.07%.

Here, though, we will look at some of the highest-yielding open-ended actively managed investment funds, filtered to include only those with at least one FE crown rating (to ensure they are widely available to retail investors).

Importantly, investors should be aware that because yield is an expression of an asset’s cash stream relative to its share price, a fund may have a high yield simply because the prices of the assets it holds have taken a hit (see the box at the bottom). For example, a share worth £1 with a dividend of 1p has a yield of 1%. If the price of that share falls to 90p, assuming the dividend paid is still 1p, the share’s yield will increase to 1.1%.

As the top 20 table below shows, several of the highest-yielding funds invest in emerging market debt: bonds issued by governments or businesses in emerging economies. The top-yielding fund, Merian Local Currency Emerging Debt, has a yield of 9.1%.Quilter Investors Emerging Markets Bond, in second place, yields 8.7%. Several other emerging market debt funds also appear on the list, including Merian Emerging Market Debt, which yields 6.5%, and Threadneedle Emerging Market Bond, which yields 7%.The fund’s hard currency equivalent (US-dollar denominated debt) yields 5.8%.

The top 20 highest-yielding active funds

Source: FE Trustnet, as at 28 January 2020. Note: FE crown ratings ranked 1-5, with 5 being the highest score.

Bond dilemma

Emerging market debt, then, is one place to find higher income. But the asset class is not for the faint-hearted. Adrian Lowcock, head of personal investing at Willis Owen, says: “It has long been seen as the riskiest area of the bond market. The political situation in many emerging market countries can be unstable, which can introduce risk and volatility.”

What’s more, many emerging market governments have a poor record on investor protection and their treatment of foreign investors. In addition, corporate issuers in emerging markets are more likely to default than their developed market counterparts. Lowcock points out that emerging market companies don’t have the same level of corporate governance as developed market firms, and that their markets are not as advanced.

Emerging market bonds are particularly sensitive to changes in the global economic outlook, and evidence of an economic slowdown often sends investors rushing for the exit.

However, Philip Matthews, co-manager of the Wise Multi-Asset Income fund, argues that investors should not write off the asset class completely. He says: “Real yields are positive in emerging markets, whereas they are negative in the US and Europe, indicating that investors in emerging market debt are better positioned to generate real returns, subject to defaults remaining benign.”

Moreover, Matthews argues, the level of emerging market debt defaults “appears to have been more benign than investors have feared, providing some  comfort in this regard.” Added to this, he notes that the asset class is underpinned by strong market fundamentals, including favourable demographic trends and relatively strong economic growth.

Currency question

Bruce Stout, manager of Murray International investment trust, is also a fan of emerging market debt. He has long argued that the current unconventional monetary policy underpinning bond prices in developed markets is risky. In contrast, he points out in The Investment Trust Handbook 2020, the influences on emerging market debt look relatively conventional. He says: “We have 18% of the portfolio in emerging market debt, which continues to look interesting because of the orthodox economics that underpins those bonds.”

The question for investors considering such high-yield funds is whether to opt for local or hard currency options. It’s a matter of risk versus reward. Darius McDermott, managing director at Chelsea Financial Services, says: “With local currency bonds, investors demand extra yield to compensate them for the additional risk of a depreciation of their home currency over time.”

This risk does not exist for bonds denominated in hard currency – usually dollars – hence the lower yields. However, that’s not to say that dollar-denominated bonds in emerging markets don’t come with hazards. With hard currency debt, an emerging economy may be forced to default or appeal to the International Monetary Fund (IMF) for help should it enter a debt crisis. IMF help often comes with a ‘haircut’ for bond investors.

McDermott says: “It’s very difficult for an average investor to decide whether to invest using a hard currency or a local one, so many investors leave it to experts to decide which is best at any given time, by opting for a fund that invests in both types.” He gives as an example of such a fund the M&G Emerging Markets Bond fund, which he rates highly. The fund is not included in the top 20 table, however, as it has a yield of just below 5.5%.

Despite the persistently low yields from government bonds in the developed world, investors there can find solid high fixed-income returns close to home.

For example, Royal London Global Bond Opportunities, while at the bottom of the top 20 list, provides a relatively attractive yield of 5.6%. The fund has more than 200 holdings, spread primarily across the US and Europe. Since its launch in 2015, the fund has been able to boast one of the strongest performance records in the strategic bond sector. It was named as one of Money Observer’s Rated Funds in both 2019 and 2020.

Derivatives boost

Several high-yielding funds that appear in the table, typically with names that include the phrase ‘enhanced income’, use derivatives to boost income. The top-yielding fund in this space is UBS Global Enhanced Equity Income, with a yield of 8.3%. That’s followed by BNY Mellon Equity Income Boosterand Schroder Income Maximiser, both of which yield 7.6%.

Schroder Income Maximiser has been a Money Observer Rated Fund for all but one year since 2013. The fund’s stated aim is to provide an annual yield of 7%. The fund cannot guarantee this payout, but it has reached this target every year since its inception in 2005.

The fund invests in stocks identified by managers Nick Kirrage and Kevin Murphy as cheap. Both Kirrage and Murphy consider themselves value investors. The third manager of the fund, Mike Hodgson, sells ‘covered call options’ on these stocks to boost the yield. The fund’s 40 or so stocks typically have a yield of around 4.5%. Hodgson’s work currently boosts that yield to 7.6%.

However, investors opting for enhanced income funds should have their eyes wide open, as these funds effectively swap future capital appreciation potential for present-day income. The fund managers sell options on the capital appreciation of the stocks they hold, receiving fees that can be used to boost yield payments.

Lowcock says: “These funds simply sacrifice some potential growth in the market and convert it into income. The funds therefore have a higher yield than other income funds, but over time you would expect them to grow more slowly than their peers in capital terms.”

Compromised capital

Ben Yearsley, director at Shore Financial Planning, is sceptical of such funds: “I’m not a great fan, as you are basically giving up capital growth prospects and, indeed, income growth prospects in exchange for more income today. Jam today, less jam tomorrow.”

Jason Hollands, managing director at Tilney Bestinvest, says it is best to view enhanced income funds as “rearranging the return profile” of assets, as capital growth is replaced with income. Whether this is worthwhile depends on the needs of the investor. Such funds can be useful for those with a pressing need for upfront income. Over the long term, however, Hollands argues that returns will be little changed. He says: “Over a cycle, the total return will be similar to the profile of the underlying portfolio.”

High-yield bond investments come with proportionate risk

High yield is often the result of a low share or bond price, so it’s important to understand why a price is low. (Our Dogs of the Footsie annual review provides some instructive case studies, Centrica being a case in point.)

Yarrow says: “The main structural risk in investing in high-yielding assets is that a high-yielding asset is one that the market doesn’t trust. Buying a high-yielding investment is not enough on its own. Investors need to know an investment’s back story in order to make a judgement on how safe the dividend really is.”

Hollands warns investors against being dazzled by a high yield alone. He says: “Sustainability of yield is important. But for many investors, so too should be an ability to grow distributions over time so that income payments will keep pace with inflation.”

McDermott also has a warning for investors drawn to high-yield investments: He says: “Build a diversified investment portfolio and make sure you have some funds that can grow their dividends to protect you in the future, as well as some that pay you the income you need today.”

Investment trusts offer alternative income options

Our top high-yielding funds table includes mainly equity and fixed-income bond funds, but there are also other high-yielding options.

Many income investors include alternative assets in their portfolios, often an infrastructure-oriented fund. Tony Yarrow, co-manager of the Wise Multi-Asset Income fund, says these funds may focus on alternative, income-generating assets such as schools, hospitals, toll roads and pipelines, and increasingly on wind, solar and biofuel power generation.

He adds: “The common element is that all these assets provide steady, long-term income, often paid by governments or large institutions and with at least an element of index-linking – and they therefore offer investors long-term, low-volatility and inflation-proofed income streams.”

They also provide diversification, which should help reduce risk.

However, funds invested in such assets are largely absent from our list of 20 top-yielding open-ended funds. This is because for infrastructure assets, which are often illiquid and hard to sell, the closed-ended (investment trust) structure is superior.

For example, Renewables Infrastructure Group investment trust, a Money Observer Rated Fund for 2019, offers a solid 5.8% yield, higher than the broader FTSE 100 index and several funds included in our table.

The trust primarily invests in assets that generate electricity from renewable energy sources. The manager’s investment process consists of picking assets based in part on identifying where the most attractive subsidies are being offered.

Investors should be aware that the trust trades at a considerable premium of more than 20%, which could leave them exposed to capital losses should the trust’s share price fall back in line with the value of its assets. However, the trust does not hold publicly traded bonds or equities, which makes it much harder to gauge the value of its assets. This can lead inevitably to a large disparity between net asset value and share price at times.

More generally, closed-ended funds have other benefits for income-seeking investors. As Yearsley notes, they can smooth income returns by “holding some income back in good years to pay out in poor years”. However, there is a lot less choice, with fixed-income and bond trusts notably absent.

Investors must consider the risk of movements in share price discounts and premiums. Yields can fall sharply as asset classes become more popular.