What are income funds?

Many of you might have heard about collective investment schemes. In fact, some time ago I had written about and explained how collective investment schemes work and how to evaluate them.

Collective investment schemes are schemes whereby the fund manager, who is normally in charge of the administration of the scheme, collects money from many different investors and, by amalgamating the sums collected, will be in a position to invest these monies in different securities in line with the objectives of the scheme.

Collective investment schemes come in many different types. For example, those investing in shares are known as equity funds while those investing in bonds are known as income funds/bond funds. A balance between shares and bonds will make up a balanced fund.

We can therefore say that income funds are funds whereby the fund manager invests the money collected from the different investors in instruments which produce income, namely bonds and other fixed interest instruments.

Income funds can also be further split into "distributing" and "accumulating" funds.

Distributing income funds are those where the income generated from the bond investments gets paid out to the investor. The frequency of the payments depends on the fund chosen but can range from monthly to yearly payments. Funds offering monthly payments are very popular in the local market.

Accumulating income funds are those funds in which the income generated gets accumulated to the capital, either via the purchase of additional units or through an increase in the price of the fund.

Income funds can also be found in different currencies, for example sterling, US dollar and euro income funds.

How does the fund manager decide where to invest the monies he receives?

The fund manager will have a set objective for each fund. For example, an income fund might invest in government issued paper only, or it might invest in corporate bonds or a mixture of both.

The investor thus has the option to choose the fund best suited to his needs and his risk profile.

The fund manager also has to decide what degree of risk he will take when investing the money available. Obviously, the higher the return (yield) being given, the higher the risk being taken.

Investors should be aware that the market is a mechanism which does not allow anomalies. This means that there is no "super" bond or fund which gives you a high rate of return without taking an equivalent risk.

Therefore, before investing in a particular fund, the investor must assess the credit rating of the underlying investments which indicates the degree of risk being taken. The table on page 31 is a guide of the credit ratings normally quoted.

A fund can be fully invested in, for example, one credit class or it can have a mixture of different risk ratings. Details should be found in the fund`s prospectus which should be perused before investing.

As can be seen, income funds, or indeed collective investment schemes in general, offer the investor the opportunity to diversify his holdings while still investing small sums of money.

Furthermore, the fact that the fund manager is not investing all the money in one bond, further reduces the risk of the investment. Therefore, the saying "don`t put all your eggs in one basket" is given great credence when investing through collective investment schemes.

Investors should also take note of the standing and reputation of the fund manager and should also consider the size of the fund in question. The larger the fund the better, since running costs, such as advertising and printing costs, would be split among more investors, keeping the cost base low.

Finally, investors should take note of the tax treatment of the income fund in which they wish to invest.

Recently, the government introduced special tax incentives for locally listed collective investment schemes which now fall under the 15 per cent final withholding tax regime. Investors are therefore urged to seek appropriate advice before investing.