Income portfolio: Buying Woodford and avoiding bond proxies

Volatility has returned to stockmarkets and this month's portfolio update shows that even the professionals aren't immune to it.

However, Gary Millward at Alan Steel Asset Management, who runs our higher income portfolio, is feeling vindicated. "No investor ever wants to have to report negative numbers, but if you look at how we have fared compared with the index, I'm really pleased. This is a difficult time to have to report, but I believe this portfolio is going to stand us in good stead," he says.

Indeed, since the portfolio launched on 1 April 2017 the FTSE 100 index is down 1.24% while the Investment Association's UK equity income sector has produced a total return of 2.7%. In contrast, our higher income portfolio has racked up a total return of 6% over the same period.

"Investors need to be pragmatic and look at things on a relative basis. We have negative numbers since the previous update but, while global markets fell 12% from peak to trough, we are down less than 3%," Millward says.

Around half of the portfolio's total return has come from its income. While the overall yield is just 3.1%, Millward points out that investors can draw down from capital gains to meet their needs. "It's hard to find yield I have confidence in," he says. "Now is not the time to chase yield."

He believes his decision to invest with a value bias – avoiding defensive 'bond proxy' stocks, which have soared in value in recent months – is finally about to pay off. "That decision didn't work well for us last year, but maybe we moved too early," he adds.

As interest rates have started to rise and are expected to continue to do so, bonds have become less attractive, which has caused yields to rise (and prices to fall). That's bad news if you're stuck in a low-yielding bond, especially if inflation is rising at the same time.

Since the last review, Axa Distribution has been swapped out of the portfolio in favour of M&G Property Portfolio. It's a move Millward was considering at the previous review four months ago after the Axa Distribution fund had a change of manager, but in the end what prompted the change were concerns about its exposure to UK bonds. With volatility creeping up, Millward therefore used the proceeds of the Axa sale to introduce a second property investment.

Certainly, if the M&G fund does as well as Thames River Property investment trust has, it will have been a great decision: the trust is up 18.6% since inception and is the strongest performer in the portfolio. It has benefited from a reversal in the negative sentiment that dogged the sector after the Brexit vote in 2016.

Also leaving the portfolio is Rathbone Income. It's the one holding that includes those bond proxy stocks Millward dislikes so much, and it has been the worst performer since inception. So he's making a contrarian bet.

Joining the group is the Woodford Equity Income fund, run by the star manager who has recently been lambasted for a string of supposedly poor stock choices. Woodford has been subject to criticism from his fans following major profit warnings from some of his biggest holdings, including the AA and Provident Financial. His fund has lagged the IA UK equity income sector for two years.

Millward says: "Woodford's underperformance tends to precede market events, so you look back and see that he was right. I don't know if that will happen again, but he's done a phenomenal job for 30 years and you don't become a bad manager overnight."

Good diversifier

Staying in the portfolio is the Miton Cautious Monthly Income fund, which could be useful if volatility continues to creep up. With its exposure to emerging market and Japanese equities, the fund doesn't take a traditional cautious approach, but it is a good diversifier in the portfolio. Its performance so far has been "unspectacular", but Millward likes the fact that it avoids defensive stocks and has one of the highest yields in the group at 3.45%.

The Invesco Perpetual European Equity Income fund has been a "disappointment" since it joined the portfolio after our previous review in November. It replaced Neptune US Income at that point, because Millward was concerned that US share prices were too expensive, but actually they have climbed even further since president Donald Trump passed a tranche of tax reforms that are expected to boost company profits.

Chelverton Smaller Companies trust is the weakest holding in the portfolio over the past four months, down 8.8% in that time. Small and medium-sized businesses seem to bear the brunt of any negative sentiment towards the UK, and funds focused on those market caps see outflows when investors get nervous. But Millward likes the fund's focus on cyclical stocks. Moreover, it also has one of the highest yields in the portfolio.

Investors may have to brace themselves for more pain over the coming months, but with a long-term strategy in mind, Millward is sticking to his guns and backing the managers who are doing the same.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation, and is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.