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How to avoid being trapped in a Woodford scenario

Tom Stevenson

Tom Stevenson - Fidelity Personal Investing

This article first appeared in the Telegraph

Neil Woodford

Flying to Beirut is an extreme way of avoiding the Woodford affair but I can recommend it. I found even the anarchy of Lebanon’s roads a relaxing alternative to dealing with the fallout from the fund suspension. With impeccable timing, it happened on the first day of my holiday. As I said in my piece before I left, moreover - while there was still time to do something about it - you’ll be relieved to hear that I intend to return to it only tangentially now.

Important as the liquidity and governance issues thrown up by this sorry tale are, what struck me from afar was the importance of clear labelling - investments doing what they say on the tin. It’s not unreasonable to think that most people invested in the Woodford Equity Income Fund because they were in search of a sustainable income - the clue is in the name. As that requirement won’t have gone away, you may be wondering what you should be looking for (and what you should avoid) to ensure a happier outcome in future? Here are six things you might consider.

First, make sure you look under the bonnet of your investments. Whatever you might think of Woodford, no-one can accuse him of not being transparent. The holdings in his funds were clearly set out on his website. To be honest, the rest of the industry has some catching up to do but even a glance at the top ten holdings can give you a good feel for where an income fund manager is looking for yield. Look for big, liquid shares and dig deeper if you have the time or inclination to check that companies have the earnings and cashflow out of which to pay their dividends.

Second, make sure that your fund manager is not falling into the trap of chasing yield without considering risk too. When I last looked, there were 10 FTSE 100 companies yielding more than 7%. While that sounds great in a low-rate environment where the Bank of England is struggling to raise the cost of money above emergency levels, these kinds of high yields should ring alarm bells. Above 6%, I start to factor in the chance that the dividend will not actually be paid. A well-managed income fund will have a mix of high-yielders and other companies with a lower initial pay-out but the prospect of a growing income stream over time.

Lesson three is to focus on capital protection as well as income. This is particularly important if you are withdrawing income from a fund (in drawdown, for example) rather than simply rolling it up into capital growth as you probably did when you were accumulating rather than living off your savings. Warren Buffett says the most important rule of investing is not to lose money. He is right, especially in the early years of drawing down an income. Capital losses added to income withdrawals can quickly deplete a fund and the sequence of market gains and losses matter - in an ideal world you will enjoy market gains early and suffer any corrections later. You will come to respect a manager who values stability as highly as income.

Related to this is the fourth lesson: there are no free lunches for income investors. There are a few income-focused funds which increase the income they pay out by selling to other investors the right to buy the shares they own at a slightly higher price than they are valued at today. The other investor pays a premium for this right (it’s known as a call option) and the fund manager uses the up-front payment to boost the underlying dividend income of the portfolio. It’s safe but it does come at a price - you are essentially gaining income today by foregoing possible capital growth tomorrow. As I say, no free lunch, but if income is your priority it can be a sensible approach.

On the subject of safety, a fifth consideration is the diversification of your income streams. Shares offer a relatively high income (the average dividend yield in the FTSE 100 is above 4%) but there are other places to go for yield too. Corporate bonds are riskier than those issued by governments, but investors are rewarded for that with a considerably higher income. Other sources of yield include infrastructure such as wind farms, toll roads, hospitals and the like. There’s even a place for cash in the few cases where it pays more than a trivial income. A multi-asset income fund will have some or all of these.

When it comes to different stock market sectors, there is plenty to choose from, especially in the UK, where companies have a tradition of paying decent dividends. Four areas are worth exploring: consumer stocks such as Unilever, Diageo and, if your conscience allows, Imperial Brands and BAT; banks like HSBC and Lloyds, which are run for return not growth; energy and utilities, albeit that these come with some political risk now; and pharmaceuticals. It’s also worth looking further afield, with the income from traditional growth markets in Asia increasing all the time.

Finally, be clear about how much income you really need and only take as much risk as you need to achieve it. The safest thing is to rely only on the natural income from your investments. You can always use the capital to buy an annuity later, when you’ll get a much better income because you are older and closer to the finishing line. Indeed, the longer you can put off relying on your savings for an income the bigger it will eventually be. Keep taking the holidays, though. I can’t speak too highly of Lebanon.

Important information

The value of investments can go down as well as up so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.