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OPINION

Income planner

Income planner
January 9, 2014
Income planner

More than anything, that's a tribute to those two great forces of investment - patience and the power of compounding; after 15 years of investing sensibly, yet with no great help from London's equity market, the income fund has grown to a size where it is throwing off really quite useful amounts of cash.

That's fine, but, from time to time, readers ask: what if you were starting an income fund from scratch today, how would you go about the task? In a way, setting up a new fund is the same as running a well-established one. Always, you are asking two basic questions: what do I want from my income portfolio and how do I go about getting it? True, the answers can change depending on the stage of the portfolio's development. In the early part, the required level of income will still be a target and, as with any target, achieving it requires taking some risks. Once the income threshold has been passed, the need to pursue inflation-busting levels of income growth diminishes and with that comes change to the nature of the portfolio - basically, less risk and more stability.

This is the right point to quickly spur off on a tangent and clarify the difference between income and yield, as the two are often confused. 'Income' is what it says - a money sum. Meanwhile, 'yield' is the ratio of an output to an input. In this context the ratio of income to value (most likely stock-market value). So the Bearbull Income Portfolio has an income of about £12,000 a year and a yield of 4.4 per cent, but it can't have an income of 4.4 per cent or a yield £12,000.

And - we're back to the main argument now - when you start running an income portfolio you may or may not have an income target in mind. However, you will certainly have a yield target, even if it's a relative target - in Bearbull's case, stock yield relative to what's offered by the FTSE All-Share index. For each holding I put into my income fund the dividend yield at the point of purchase must be at least 1.2 times the All-Share's. This maximises the chance that I will get a decent amount of income from the fund (even if I struggle to define 'decent' with numerical precision) and minimises the likelihood that I will fill the portfolio with dross.

As with any income portfolio, that's ever the danger. A big fat dividend yield is always a temptation, yet the higher the yield on offer, the greater the chance that you are buying rubbish and/or the pay-out is unsustainable. So, in pursuit of income, accept the simple truth that there is an inverse correlation between yield and quality. Yield is partly the function of what the market thinks about a security and much of the time it is smart enough to know a dog when it sees one. So the higher the yield, the more likely it is that all you're getting is some upfront consolation of a dividend or two before the misery sets in. For every Chesnara (CSN) or Smiths News (NWS), whose shares offered a yield of 9 per cent plus before they went on to post great returns, there are umpteen junk equities that axed their dividends and were forgotten.

That said, markets do systematically overreact so shares in good quality companies can - and do - offer excess yields when they are out of favour. Then they generate good returns as mean regression gets to work. This assumption - that mean regression will produce good, long-term returns - lies behind much of Bearbull's stock picking for the income fund. It's why blue chips such as GlaxoSmithKline (GSK), Vodafone (VOD), even BP (BP.) are there to balance the risks of higher yielding picks, such as Real Estate Credit Investments (RECI) and Zytronic (ZYT).

Having bought a share, don't worry if its rising price forces the dividend yield below the threshold you set. That's a function of success, so enjoy it. It's only if the overall yield of the portfolio drops below your threshold that you have a decision to make. Even then, is the cause rising prices or falling dividends? If it's the former, that implies good selections - well done. Tighten your stop losses and, so long as the outlook for your chosen companies seems good and dividend income is rising, do little else. If it's the latter, you have problems. Identify them and deal with them.

Easier said than done, I know, but that's the aim. In the meantime, is now a good time to be starting an income portfolio? Is there ever a good time? The 'dash for cash' that forces down yields everywhere doesn't help, but next week I will make a stab of putting together a small yet diversified high-yield portfolio from what's on offer today.

Returns from the Bearbull Income portfolio over the past three years:

Year ended Pay out (£)ChangeFund yield (%)Cumulative (£)
20111st half5,650-7%4.691,149
 2nd half4,9982%4.396,147
 Total10,648-3%4.4 
20121st half4,741-16%4.1100,889
 2nd half5,2245%4.4106,113
 Total9,965-6%4.3 
20131st half5,75821%4.4111,871
 2nd half6,47624%4.5118,347
 Total12,23423%4.4