Most investors want markets to shoot up making them great profits, but Nick Purves and Ian Lance, managers of the RWC Enhanced Income Fund (LU0539372507), prefer stable and predictable businesses.
Mr Purves argues that over time lower volatility produces better risk adjusted returns as it is difficult to make up lost performance. For example, an investor who makes 20 per cent in one year and loses 20 per cent the next does not end up where he started but is actually 4 per cent below the start point. The larger these figures, the more pronounced the effect: an investment which halves needs to go up by 100 per cent to get back to the start point.
As a result of their investment approach this fund has lower volatility than the FTSE All-Share, the index it is measured against. Over 2012 the FTSE All-Share's volatility was 15 per cent against 10 per cent for the fund. "The shares we own are also defensive in falling markets and we will hold cash when valuations are expensive," he adds. "We take a number of steps to dampen down volatility because if we do this we will end up with a smoother income stream."
Mr Lance and Mr Purves have an added incentive in keeping things stable as RWC Enhanced Income is not a plain vanilla UK equity income fund. It makes around half its income from investing in shares and half from selling options on the shares. This results in a higher yield than on many equity income funds, currently 7 per cent. However if a share on which an option is sold rises above a certain pre-determined level, the upside is capped. So in a rapidly rising market, this fund will lag more conventional funds but does better in gently rising, sideways or falling markets.
Ian Lance
This is not dissimilar to (IC Top 100 Fund) Schroder Income Maximiser (GB00B0HWJ904) which Mr Purves and Mr Lance ran until 2010.
A considerable fall in markets also detracts from returns. "So we want stable and predictable businesses which will rise over time," explains Mr Purves. "This is a contrast to Schroder Income Maximiser, which we ran with a deep value recovery style looking for distressed and volatile shares. The portfolio was basically a replication of our income fund's holdings over which our structured products team did an overlay. Here we focus more on the volatility of the dividend the fund pays in absolute terms."
Last year RWC Enhanced Income slightly lagged the wider market. "But we were not disappointed because this was achieved with a lot less risk, while the dividend cheque boosted the overall return," adds Mr Lance. "If you want to maximise total return there are hundreds of other funds out there for that. We are more focused on having a smooth income stream and seek positive returns over a market cycle - around five years."
But that doesn't mean they disregard total return and seek income at the expense of it. "It would be easy for us to buy a load of high yielding utility stocks but we don't own these because although they give a good income they also risk a potential capital loss," says Mr Lance. "And some pay uncovered dividends."
When it comes to picking the shares, Mr Purves and Mr Lance still have a strong valuation bias, so do not currently hold consumer staples popular with income investors such as Diageo (DGE) and Nestle. They use normalised earnings and balance sheet adjustment to assess intrinsic value.
"Profits stand at record levels but they have always declined from these high levels. Therefore, in a number of sectors this creates a dilemma for investors: should they invest on the basis that profits can continue to grow from already extended levels or should they take the more conservative approach which assumes an element of mean reversion at some undeterminable date?
"We prefer to take the more conservative approach as we believe that on the basis of cyclically adjusted valuations many of these sectors look very fully priced and give investors little or no margin of safety against any deterioration in profitability from today's elevated levels. We are therefore avoiding these areas which in our view include mining, chemicals, industrials and luxury goods."
Better areas include pharmaceuticals, telecoms and insurance, and examples in the fund include top 10 holdings GlaxoSmithKline (GSK), AstraZeneca (AZN), Vodafone (VOD), Legal & General (LGEN), Standard Life (SL.) and RSA (RSA).
Nick Purves
As well as a low valuation, they seek companies with high cash flow generation and low volatility. "Trying to marry these in today's market is difficult because the prices you are being asked to pay are not commensurate with the returns you expect, while cheaper shares, for example banks, may not be paying dividends or have a volatile cash flow."
Low valuations are also a way to mitigate volatility. "The last few years have seen some fund managers buy companies with less volatile streams of earnings (such as consumer staples) as a proxy for low volatility investing with the results that some of these companies are more expensive today than they have ever been," says Mr Lance. "If one objective of a low volatility fund is to produce an element of down side protection, we still struggle with the idea that buying very expensive assets is a good way to achieve this."
Liquidity is also an important consideration for them when choosing shares because if you have options on a share it can cause problems if the share is not liquid.
"Our biggest concern is a significant drawdown that would kill enthusiasm for equities," says Mr Purves. "That said, our fund would mitigate this and it could also provide opportunities for finding companies at low valuations."
