How we invest to pay a monthly income

Kyle Caldwell, interactive investor’s Collectives Editor, speaks to Jacob de Tusch-Lec, fund manager of the Artemis Monthly Distribution fund. As part of a wide-ranging discussion, Jacob explains how the fund is structured to pay a monthly income, why he has been reducing equity exposure, and points out the weak pound has proved to be a silver lining for a few holdings.

Artemis Monthly Distribution is a member of the interactive investor Super 60 list of investment ideas.

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today I have with me Jacob de Tusch-Lec, fund manager of the Artemis Monthly Distribution fund. Jacob, thanks for coming in today.

Jacob de Tusch-Lec, fund manager of the Artemis Monthly Distribution fund: Thank you for having me.

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Kyle Caldwell: So, Jacob, the fund invests in both equities and bonds, what is the typical split? And I also understand that you've been recently reducing exposure to equities?

Jacob de Tusch-Lec: Yes, so the bond component is usually between 50% and 55%. And we don't tend to move it around a lot where there is an asset allocation exercise to be done. And as you point to recently, we've been taking equities down because bonds are yielding again after almost a decade of not yielding. Now, we can actually get income from the bond side, which is great. There are some side effects, but we can talk about those later. But it's great that we can get income from the bond side of the portfolio. So, we've increased that.

And you could argue that the bar has increased for equities because now we need to get a proper yield there. What we can do, though, is not just move around the equity/bond allocation, but within equities we can, for example, decide to buy more listed infrastructure and that has bond-like characteristics. We can decide to maybe buy some mortgage rates or some apartment rates or get some real estate backing in there. So, it’s not just about bonds and equities. It's also what kind of equities we have and what kind of asset classes are sitting supporting those equities.

Kyle Caldwell: And in providing a monthly income to investors, do you have to be strategic about when the income is paid by the shares on the bonds?

Jacob de Tusch-Lec: We do look at ex-dividend dates. For example, in Europe, companies pay dividends once a year. It’d be a bit silly to hold a stock for 11 months and then sell it the day before you get the dividend. But, broadly speaking, the dividend is sort of part of the investment process. So, the idea is that if we hold the right stocks at the right time, we will ultimately end up collecting enough income to pass on to clients, but the total return is important as well. So, we are not going to hold the stock for two months just because the dividend is coming in two months’ time. The investment universe is big enough for us, it's a global remit both for the bonds and the equities. So, you can always go somewhere and get some income. We tend to sort of sweep up income as we go along, but it is quite lumpy for the end client.

Kyle Caldwell: You mentioned that the income is lumpy, so how does it work in practice? How does the fund pay the monthly income?

Jacob de Tusch-Lec: It’s not smooth. It’s sort of a bit, what do we have to deliver? We can smooth a bit. But ultimately, this is an instrument we expect clients to hold for the longer term. Also, many clients hold accumulation shares so they don’t actually get the dividend paid out. So, we try not to tinker too much with it and just say we are investing in companies that pay a high dividend yield. We're investing in bonds that give you a nice income and we give you a bit of asset allocation.

Kyle Caldwell: Year-to-date it's been a very challenging period for both equity and bond markets. And with bonds, they’ve not provided the same level of protection as they have done historically when stock markets have fallen. So, what’s your view on the bond market sell-off? Has it been overdone or is there more to come? And just to give our listeners some context, I am asking this question on the day that sterling hit a record low against the US dollar.

Jacob de Tusch-Lec: You're right, it's been very challenging for bonds because we've seen rates go up the most they have for decades. Inflation is at multi-decade high, and volatility is very high as well. And this sort of, usual diversification you get, you know, when equities go down, bonds go up because rates go down and there is this sort of diversification effect, we haven't really seen that this year.

And more importantly, some bond funds have gone down more than equities, which is not usually what you would expect when equities are down. So, you could argue that the beta is much higher on the bonds than you would expect, and that's challenging, I don't think it's entirely surprising because that's what happens when central banks raise rates and you have inflation, financial assets go down and bonds might be safe, but they are financial assets and they got very expensive after a decade of very low rates.

What we tried to do is just to say, where are the sweet spots within each asset class? Where do we think we're getting enough income for the risk we're taking? And although we don't get the full diversification effect that we would in a normal year, we are getting some because at least we're spreading the risks as much as we can.

Kyle Caldwell: As you mentioned earlier, the silver lining to the bond market sell-off is that bond yields are at their most attractive levels for several years as a result. Does this mean that the income being generated by the fund will increase in the years to come?

Jacob de Tusch-Lec: There are a lot of moving parts behind the scenes and one is currency. And obviously we're going through a time now where sterling is depreciating. So, for the equities that I hold in non-sterling currencies, giving you an income diversified away from sterling, that gives us a bit more growth because per definition you are collecting $1 here, €1 here, well, they have just gotten X% more valuable in sterling.

The same with some of the bonds, you're getting a coupon in a different currency. There is some hedging on that side to avoid too much currency volatility. But broadly speaking, sterling weakness is a positive for us because we're getting this overseas income. On the bond side, yes, your entry point is such that you're getting a higher yield. But, of course, if inflation continues at pretty high levels, and I would say I don't think that would be the case, but it's also not going to come down to 2% anytime soon. So, we're going to be at a higher level than we've gotten used to. Entry point on the bond side is, yes, you're getting a nice income compared to inflation. But, of course, these are fixed coupons. They don't grow over time. That's where the attraction of equities come in because on the equity side we hope we can grow the dividend anywhere between 3% and 8%, assuming the currency is fixed. And that gives you a little bit of inflation protection on the equity side. The objective of the fund is in the medium term to grow the dividend in sterling irrespective of what the currency does. So hopefully by having a better entry point on the bond side and higher dividend growth on the equities side, overall the income should grow over time.

Kyle Caldwell: Among the equity holdings, I understand there's a focus on defensive businesses. Could you explain the key qualities that you look for in a company and give us a couple of stock examples?

Jacob de Tusch-Lec: What we try to do is to look for companies where the dividend is high. The starting point is a high dividend, let's say 5%, for example, where we think that dividend is underpinned by the free cash-flow generation of the business. So, no funnies, no asset sale, actual cash generated by the underlying business on a day-to-day basis. And then we look at the balance sheet. We don't want balance sheets to be incredibly stretched because when rates go up, spreads go up, cost of lending goes up, and the dividend is at risk. So, we try to look for companies without too much debt. That tends to put us into what I would call rather boring sectors, but boring is good in this instance.

So, the fund tends to have a lot of exposure to pharmaceuticals, utilities, so maybe concession businesses such as toll roads, bridges, etc. As it happens, now we also have exposure to commodities, to a larger extent than usual because we think when inflation is high you want to have some assets underpinning it. So, the umbrella we put around a lot of our exposure is around asset backing. In a world where you have inflation, you want to have some tangible assets and a lot of the exposure in the fund, although it's in different sectors, the common denominator is that you have some assets in the ground or above ground underpinning those cash flows.

I could mention AvalonBay Communities Inc (NYSE:AVB), which is the biggest apartment REIT in the US, or the biggest listed one. They have a fair amount of debt, but they can raise their rents every time a tenant moves out. A new tenant moves in, rents go up, and that should offset the higher funding costs that they have, but also inflation. So that's a stock that we like. You’ve got some real buildings underpinning the income, you've got a tight housing market in the US, and there's demand for high-end real estate in good places [such as] New York, Miami, and Texas. Even if the economy slows, you still have got to live somewhere. So, we like those dividends that are coming out of something where you've got a tangible asset behind it and you have a management team committed to the dividend and committed to growing it.

It doesn't mean that there aren't risks here, as I said before, leverage is always an issue. Those are the kind of companies that we like. So, we will have exposure to REITs, we have exposure to utilities, and we've got utilities in the US as well. Long-term contracts underpinned by that. In Europe, we’ve got Vinci SA (EURONEXT:DG) in France, which is the biggest owner of toll roads, bridges, airports, long-term concessions. Of course, here we’ve got risks such as Covid, [and] risks like government intervention; will they allow the Vinci to put up the tolls on their roads? So, in theory, with higher bond yields, some more income when we buy the bonds and companies where the dividend is underpinned, our ambition is that the income grows over time from both bonds and equities.

Kyle Caldwell: Jacob, thank you for your time today.

Jacob de Tusch-Lec: Thank you.

Kyle Caldwell: That's all we have time for. You can check out the rest of our Insider Interviews on our YouTube channel where you can like and subscribe. Hopefully see you next time.