Diverse Income Trust plc (LON:DIVI) Co Fund Manager Gervais Williams caught up with DirectorsTalk for an exclusive interview to discuss pound cost averaging, equity income strategies and the value of UK equity income funds to mitigate the risks and extend the duration of their pension pot.
Q1: Gervais, could you outline the concept of pound cost averaging and why reverse pound cost averaging is relevant to those with a pension pot seeking to generate a retirement income?
A1: It’s long been known in the industry that if you have a small sum to save each month to accumulate a capital sum in the longer term, one of the advantages of that is when you get market volatility, perhaps when the unit price on the fund you’re trying to save into is particularly high, you tend to save a relatively small number of units.
Importantly, when volatility drives down the unit price to very low levels, at that stage you buy quite a lot of units, and this ability to buy less units when it’s high and more units when it’s low is called pound cost averaging. It ultimately leads to a slightly higher savings sum as you get the advantage of market volatility.
Specifically, in terms of reverse pound cost averaging, then of course you’re looking at people who already have savings and they’re looking to take a pension income out of those savings. If you take a regular sum out of a fund, if it’s very volatile then you take a relatively small proportion out when the market’s very high but you take a much larger proportion out when the market’s lower.
This feature, reverse pound cost averaging ultimately has the danger that the sun you have invested declines at a faster rate than you might have expected, particularly when market conditions are volatile.
Q2: So, in this context then, with inflation, can you explain how the risk of amplified stock market drawdowns and extra stock market volatility might affect the life of pension pots invested in funds that generate returns principally from capital appreciation?
A2: If you happen to be invested principally in a fund which is generating very good returns because it’s driven by the strong performance of markets and the high performance of some of the growth stocks where there’s relatively little income, the proportion you’re taking out of the fund each month is relatively significant rather than the income because the income is very small.
So, coming back to that, when you get volatile times, these kinds of funds have two disadvantages. One is because they zipper up and down more, it means that you can sometimes end up taking quite large proportions from these funds when they’re weak.
Most particularly, if inflation is around, as it is currently, you may actually want to take out a larger sum in absolute terms and so you get double helpings of reverse pound cost averaging, which is particularly disadvantageous.
Ultimately, one of the solutions to this is to invest in funds which actually generate good and growing income because then you are less reliant on taking encashment from your fund and you’re less vulnerable to the life of your pension pot being reduced.
Q3: Surely that potential disadvantage is offset by the history of equity income funds because they deliver weaker returns rather than capital growth strategies over recent decades?
A3: Yes, that’s true. What we have seen is during the period of globalisation, those companies which we able to expand at a faster rate, have more ambitious growth plans, were often very well positioned to take advantage of the strength of cash in the equity markets, cash in the credit markets means they could invest faster. Many of these companies are quite cashflow negative and they can expand faster and their share prices are often outperformed.
When we get periods of inflation, such as currently, what you see if interest rates going up and cash becomes a bit of a shortfall, markets aren’t as reliable. At those times, companies generating surplus cash are actually less likely to go bust, but they’re able to continue investing, they’re able to take advantage of the weakness of others. So, if there’s zombie companies which fall over, they can move into their marketplaces.
Most particularly, therefore, we expect equity income stocks to start outperforming funds which are more capital growth and we’ve seen that actually. If you take the UK stock market, the largest companies, the FTSE 100 for example, over the last 2.5 years, it’s pretty much the best performing stock market in the world, it’s more of an equity income bias, these are low volatility type stocks.
Most particularly, most investors got too many capital growth strategies and they haven’t got enough of the cash compounding lower volatility equity income funds and so we’re seeing this balance beginning to reverse and that’s driving out the performance of the equity income sector which is very counterintuitive with our experience in the last 10 or 20 years.
Q4: Even if equity income strategies are more relevant, surely the weak prospects for the UK economy suggests that the UK stock market isn’t a good home for long term investors currently?
A4: It’s interesting this, a lot of people assume that if your economy isn’t doing well then, the stock market wont do well but of course, many of the UK quoted companies, particularly the largest quoted companies in the UK, are dominated by overseas sales. Yes, they’re affected by the UK economy but they’re much more dominated in terms of return by the international market.
So, you can get periods when the UK stock market itself outperforms global markets. If you go back to the 60’s, 70’s and early 80’s, the UK stock market, the FTSE All-Share Index typically greatly outperformed the S&P 500, even in constant current terms. So, it’s very counterintuitive, and you get periods when markets are short of cash, as we do have now, when inflation’s high, and that tends to lead to a different pattern. Indeed the UK equity market can outperform and has outperformed in the past when the underlying markets themselves have been relatively unsettled, and that’s where we are now.
So if anything, we’re quite upbeat about the potential for the UK market to outperform. In part because it’s underperformed for so many years, it’s starting at low valuation, in part because so many investors don’t have significant weightings in equity income funds, we’ll think they’ll increase weightings, and in part because they cannot just survive but thrive during uncertain periods of economic worry.
Q5: Does it matter is investors prefer a regular income from the accumulation units of an equity income fund verses taking the more uneven stream of income from income units?
A5: Bizarrely, this reverse pound cost averaging issue even affects it if you happen to buy accumulation units. If you take £1,000 from each of the 12 months or wait for the income fund to produce £12,000 worth of income, albeit less even, I think then because you are redeeming at times when markets are volatile, you can end up that actually the reverse pound cost averaging feature can even then lead you to a slightly short of life of your fund than if you had just held purely the income units and just taken the income when it arrived.
So ultimately, even when you’re in the equity income fund, it’s important to buy the income units rather than the accumulation units.
The Diverse Income Trust invests primarily in quoted or traded UK companies with a wide range of market capitalisations, but a long-term bias toward small and medium sized companies.
