Goals-Based Investing

How equity income funds have evolved to meet retiree needs

By Thomas Young
Sydney, Australia

Over time there have broadly been three generations of equity income funds. Each has their individual purposes, strengths and weaknesses and will suit different investors. The funds have constantly evolved to better meet the needs of income-seeking, retired investors.


1. First Generation - Value Rebadged Fund

The introduction of Australia’s dividend imputation system (which removed the double taxation of dividends, once by the company and then again by the shareholder) saw some of the first generation equity income funds launched - specifically to meet the needs of investors looking to take advantage of the new law and minimise their tax liabilities.

Traditional ‘value’ fund managers look to invest in undervalued stocks in order to benefit from any rise in value when the stocks are rerated. This strategy tends to naturally favour higher-yielding stocks, as undervalued stocks can have relatively high yields. Therefore it was simple for value managers to launch equity income funds, termed ‘value rebadged funds’, using the same management strategy they already applied to their existing value funds.

Value rebadged funds are not managed for the retired, income-hungry investor. First, there is no focus on tax efficiency. These funds generally have low portfolio turnover; a buy and hold strategy is often used while the manager waits for the undervalued stocks to be rerated. The manager does not trade in and out of stocks to get maximum benefit from franking credits (as retirees in the super system should, given the advantages they gain from receiving fully franked dividends and their 0% tax rate for capital gains).

Secondly, these funds do not aim to pay smooth, consistent, monthly income (as a salary did when the investor was working).

2. Second Generation - Buy/Write Funds

In an environment of falling interest rates, with the GFC fresh in people’s minds, the idea of an equity income fund that could reduce volatility while delivering a higher-than-market yield grew in appeal. Second generation equity income funds look to deliver as high a yield as possible.

Second generation funds produce the additional income through the use of derivatives or more specifically, options. By buying shares then selling options (known as ‘writing’ options) on those shares the fund manager is giving the option buyer the right, but not the obligation to buy the stock for a set price before a set date in the future.

The capital raised from selling options is paid out to investors as income. This complicated technique can be very income-generative for a fund, lifting the total yield as high as 10% including franking credits in some cases. But, similar to the first generation funds, in most cases buy/write funds make their income payments quarterly which again will not replace the monthly salary an investor received pre-retirement.

A side-effect of using this options strategy is to reduce the funds’ beta or volatility, which also lowers the funds’ risk.

The problem, however, is that lower volatility also means the second generation of equity income funds will likely underperform when markets rise. Although investors receive higher income payments from the fund writing options, they are giving up some of the potential upside in terms of capital growth.


3. Third Generation - Goals-based Funds

Following the realisation that neither the first nor second generation of equity income funds truly met the needs of a retiree – to replace a salary by paying a smooth, regular, tax-effective, income from a portfolio with lower volatility than the market, which rises with the cost of living – the next generation of equity income funds evolved.

These funds have been designed by looking at retirees’ needs and then creating a solution, rather than trying to fit retirees into an existing product.

Goals-based equity income funds look at an investor’s life requirements, the needs and ambitions that are the centre of their attention, and aim to match these requirements with specific investment strategies.

To meet retirees’ essential needs, some third generation funds declare their estimated income in advance and ensure that the income payments are smoothed so that a similar level of income is paid each month. This is unlike the previous generations of equity income funds, where the level of income distributed could be highly varied, depending on the dividends and capital gains that the fund has received from its underlying holdings. As the third generation of funds are designed to replace a salary, retirees should know their estimated ‘pay’ for the coming months. This helps retirees by providing some certainty around expected income received and enables them to budget and plan ahead.

Another benefit of goals-based funds is related to tax efficiency. As most investors looking for income are retirees some goals-based funds have been designed with a focus on tax-aware management to maximise the income received from the investment. For example, a focus on paying a higher after-tax return will particularly benefit retirees in the superannuation system (0% tax), but also those in the accumulation phase in the superannuation system (15% tax). Stocks in the portfolio are regularly traded to maximise the amount of franking credits received.

The third generation of equity income funds seek to deliver lower volatility than the market, while retaining just enough risk to aim to provide capital growth above inflation over time. This means that the income paid by the funds should also grow above the rate of inflation to mitigate the rising cost of living.

Finding Solutions

It is paramount to ensure retirees have enough funds to live their desired life in retirement. With Australians facing the prospect of a longer retirement, many investors are now realising that the income based financial products of the past may not fully meet their financial needs.

A third generation equity income fund can alleviate much of that fear by delivering the regular income and inflation-beating growth to ensure retirees can pay for their everyday expenses in retirement.

For more information about the AMP Capital Equity Income Generator.

AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMPCFM) is the responsible entity of the AMP Capital Australian Equity Income Fund, known as the AMP Capital Equity Income Generator (Fund) and the issuer of the units in the Fund. To invest in the Fund, investors will need to obtain the current Product Disclosure Statement (PDS) from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232 497) (AMP Capital). The PDS contains important information about investing in the Fund and it is important that investors read the PDS before making a decision about whether to acquire, or continue to hold or dispose of units in the Fund. Neither AMP Capital, AMPCFM nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this information. Past performance is not a reliable indicator of future performance. While every care has been taken in the preparation of this information, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This content has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors should, before making any investment decisions, consider the appropriateness of this information, and seek professional advice, having regard to their objectives, financial situation and needs.

  • Equities
  • Goals-Based Investing
  • Income
  • Retirement
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